How is Income Tax Calculated?

Following on from our last blog where we attempted and hopefully succeeded in demystifying qualifying earnings, we thought it would be worth doing something similar with income tax.

To quote HMRC, “Income Tax is a tax you pay on your income”, which basically means income tax will be levied on a proportion of gross earnings each pay period.

Income tax will vary depending on the employee’s tax code and earnings. It is common for an employer to ask why one employee is receiving a lower net pay than another employee who earns the exact same gross pay. There are many reasons why the two employees can come out with different net pays, but one of those reasons is the tax code each employee has, and subsequently what their respective Personal Allowances are.

What is Personal Allowance? This is the amount of tax-free earnings an employee has in any given tax year. It is worth noting employers and employees NI free pay is based on different rates and is different to the Personal Allowance. The standard Personal Allowance for 21/22 is £12,570, which translates to the tax code 1257L. An employee on the tax code 1257L will not pay income on earnings below £12,570 for the tax year, however, the allowance is proportioned per pay period and income tax is calculated on a year-to-date basis.

As an example, if a monthly paid employee has the tax code 1257L, which provides tax free pay of £12,570/12 = £,1047.50 tax free pay each month. If the employee were to stay below £1,047.50 for the month 1 (April) payroll, they would pay no income tax. However, once they go over their Personal Allowance for the month, they will start paying income tax @ 20% on all earnings over £1,047.50 that month. Higher rates of income tax will be deducted depending on the employees’ earnings. Below is a table from HMRC showing the different income tax brackets,

BandTaxable incomeTax rate
Personal AllowanceUp to £12,5700%
Basic rate£12,571 to £50,27020%
Higher rate£50,271 to £150,00040%
Additional rateover £150,00045%

At this point it’s worth focusing on the previously mentioned point that income tax is calculated on a year-to-date basis. In the example above we discussed month 1 (April), but what happens when we start to progress through the tax year? Well, if we are in month 2 (May) and the employee has the code 1257L they will have two months tax free allowance,

12,570/12 x 2 = £2,095 tax free pay

As income tax is calculated year-to-date you need to use the earnings year to date. If the employee earnt £2,000 in both April and May, YTD they have earnt gross £4,000. As per the calculation above they have £2,095 tax free pay, which you then deduct from the YTD earnings,

4,000 – 2,095 = £1,905 taxable earnings

20% of 1,905 = £381 income tax YTD

 It is important to remember this is the YTD tax, not the tax deducted in month 2. The amount of tax payable in month 2 would be the tax YTD minus month 1 income tax.

A really useful report is the P11, this allows you to run through the tax year seeing how tax is being calculated as an employee progresses through the tax year.

I’ve spoken about income tax being calculated on a YTD basis numerous times in this blog, but there is an exception when income tax is calculated on the current pay period being paid. This happens when an employee has a week 1/month 1 tax code, otherwise known as emergency tax codes. These codes will either have W1, M1 or an X after the tax code, eg 1257L W1, 1257L M1 or 1257L X.

As an example, if an employee has a tax code 1257L M1 and was paid £2,000 in month 6 (September), the income tax calculation would be,

12,570/12 = £1,047.50 tax free paid

2,000 – 1,047.50 = £952.50 taxable earnings

20% of 952.50 = £190.50 income tax due

In the example above it doesn’t matter how much was earnt in the previous tax months in that tax year, the income tax is only calculated on the taxable earnings within that pay period.

I hope this blog serves as a useful guide to how income tax is calculated. It is a big subject and in fairness we haven’t been able to cover all areas. In future blogs we will look at different areas of income tax, but in the meantime HMRC has useful resources for further reading. If you have any questions, please drop us a message.