What is PAYE tax?

Published on December 04, 2023
by Darryl Albuquerque

Darryl Albuquerque, an IRS Enrolled Agent with 19 years of expat tax experience, specializes in US tax preparation, tax planning and tax advice for US citizens and Green Card holders living and working in the Middle East. Darryl also specializes in helping clients through the Streamlined Tax Amnesty Program.

PAYE, or Pay As You Earn, is a method of tax collection in the UK where income tax and National Insurance contributions are deducted directly from an employee’s wages or occupational pension before they receive their pay.

This system is widely used in the United Kingdom and ensures that the tax obligations of employees are met regularly and efficiently throughout the financial year. This method spreads the tax payment over the course of the year, aligning with each pay period, whether that’s weekly, monthly, or another interval.

The system is similar to PAYG (Pay As You Go) in Australia.

How does the PAYE system function?

The mechanics of the PAYE system involve several key steps:

  • Tax Code Assignment: Each employee is assigned a tax code by HM Revenue & Customs (HMRC). This code indicates the amount of tax-free income the employee is entitled to in the tax year and helps employers calculate the amount of tax to deduct.
  • Regular Deductions: Employers use the tax code and HMRC’s guidelines to calculate the amount of income tax and National Insurance contributions to deduct from each payment to the employee.
  • Reporting to HMRC: Employers report these deductions to HMRC and transfer the collected taxes to HMRC on behalf of their employees.
  • Year-End Adjustments: After the end of the tax year, HMRC reviews the records. If an employee has paid too much or too little tax, HMRC will adjust the tax code to correct the discrepancy in the next tax year.

For U.S. expats working in the UK, understanding the PAYE system is crucial as it directly impacts their take-home pay and tax compliance. It’s important to ensure that the correct tax code is used to avoid overpaying or underpaying tax. This is why it’s beneficial to consult a tax professional, they can provide tailored advice and ensure compliance with both UK and U.S. tax laws, helping to avoid any unforeseen tax liabilities or penalties.

Who needs to comply with PAYE taxation?

PAYE taxation is a requirement for all employers in the United Kingdom who have employees earning above a certain threshold. This system is applicable to all types of employment, including full-time, part-time, temporary, or casual workers. Essentially, if an individual is an employee receiving a salary or wage, their employer is responsible for deducting PAYE tax and National Insurance contributions from their earnings.

The PAYE system covers various forms of employment income, including:

  • Wages or salaries from employment.
  • Pensions from former employers.
  • Some state benefits.

Self-employed individuals, however, are not subject to PAYE. They are responsible for their own tax and National Insurance contributions and typically pay these through self-assessment.

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How is PAYE tax calculated?

The calculation of PAYE tax is based on an individual’s income and their tax code. The tax code reflects an individual’s allowance-–the amount of income they can earn in a year before they start paying tax.

Tax Code

The tax code is determined by HMRC and sent to the employer. It considers various factors, including the personal allowance and any additional allowances or deductions. Tax codes in the UK are typically made up of numbers and a letter. The numbers represent the amount of income you can have before paying tax, and the letter indicates your situation and how it affects your personal allowance.

For example, the tax code ‘1250L’ was common in previous years, where ‘1250’ indicated a tax-free personal allowance of £12,500.

Income Bands

The UK has different tax bands and the rate of tax increases as income increases. These bands determine the percentage of tax applied to different portions of an individual’s income.

Personal Allowance: Up to a certain amount (£0 to £12,570), income is tax-free.
Basic Rate: The next portion of income (£12,571 to £50,270) is taxed at the basic rate (20%).
Higher Rate: Above the basic rate, income (£50,271 to £125,140) falls into the higher rate band (40%).
Additional Rate: Income (Over £125,140) above a higher threshold is taxed at the additional rate (45%).

National Insurance

Alongside income tax, National Insurance contributions are also calculated and deducted under the PAYE system. These contributions are calculated as a percentage of earnings above a certain threshold.

For the most accurate and current tax codes and income bands for 2023, we recommend consulting a professional tax advisor. When dealing with international elements, seeking advice from a tax professional can be beneficial. They can assist in navigating both UK and U.S. tax systems, help in understanding the implications of your employment income, and ensure that you are compliant with all necessary tax obligations. This guidance is invaluable in managing your financial responsibilities effectively while living abroad.

What constitutes employment income under PAYE?

Employment income under the PAYE (Pay As You Earn) system includes any earnings an employee receives from their work, which are subject to income tax and National Insurance contributions. This encompasses a range of income types, not just the basic salary.

Taxable employment income under PAYE typically includes:

  • Salary or Wages: The regular payments an employee receives for their work.
  • Bonuses and Commission: Additional earnings based on performance or sales.
  • Overtime Pay: Extra pay for hours worked beyond the normal working hours.
  • Statutory Payments: Such as statutory sick pay or maternity/paternity pay.
  • Benefits in Kind: Non-cash benefits like company cars, accommodation, or health insurance.

What are employers’ responsibilities in PAYE?

Employers play a crucial role in the PAYE system, as they are responsible for deducting tax and National Insurance contributions from their employees’ earnings and paying these to HM Revenue & Customs (HMRC).

Key responsibilities of employers under PAYE include:

  • Deducting Tax and National Insurance: Using the tax codes provided by HMRC, employers must calculate and deduct the correct amount of tax and National Insurance from their employees’ pay.
  • Reporting to HMRC: Employers need to report these deductions to HMRC, typically through Real Time Information (RTI) submissions.
  • Issuing P60 and P11D Forms: At the end of the tax year, employers must provide employees with a P60 form summarizing their total pay and deductions for the year. If employees receive benefits in kind, employers should also provide a P11D form.
  • Handling Employee Queries: Employers should be able to address basic queries from employees about their tax codes and deductions.

What should employees do about PAYE?

  • Payslips: Employees should regularly review their payslips to ensure that the correct amounts are being deducted for tax and National Insurance.
  • Verifying Tax Codes: Each employee is assigned a tax code by HMRC, which determines how much tax should be deducted from their income. Employees should verify that their tax code is correct to avoid overpaying or underpaying tax.
  • Reporting Changes: It’s important for employees to inform their employer or HMRC about any changes that might affect their tax, such as a change in employment status or additional income.
  • Annual Tax Summary: Employees should review their annual tax summary from HMRC for accuracy and understanding of their tax contributions.

The PAYE system and tax codes are vital to ensure correct tax payments. However, given the complexities of tax laws, especially when dealing with international elements, consulting with a tax professional can be highly beneficial. A tax expert can provide guidance on UK tax obligations, help in understanding and correcting tax codes, and ensure compliance with both UK and U.S. tax laws. This professional assistance is invaluable for managing financial responsibilities effectively while living and working abroad.