Pension tax relief is a way that the government uses the tax system to encourage employees to save for the future. With minimum auto enrolment pension contribution rates set to increase again from 6th April 2019, here is a useful guide for employees and employers to understand how tax relief works on pension contributions paid via payroll. There are 2 ways in which this works:
Pension contributions = £2,000.00 x 2.4% (i.e. 80% of 3%) = £48.00. HMRC top up the employee’s pension pot with the remaining 20% which is £12.00 (i.e. £2,000.00 x 0.6%). The employee ends up with £60.00 in their pension pot.
Tax at 20% = £2,000.00 x 20% = £400.00
Therefore, take home pay = £2,000.00 - £400.00 (tax) - £48.00 (pension) = £1,552.00
Pension contributions = £2,000.00 x 3% = £60.00
Tax at 20% = £1,940.00 (i.e. £2,000.00 gross earnings less £60.00 pension contribution) x 20% = £388.00
Therefore, take home pay = £2,000.00 - £60.00 (pension) - £388.00 (tax) = £1,552.00
Comparing the two, we see that both employees end up with the same amount in their respective pension pots and the same take home pay: Employee A pays £48.00 via payroll and gets a top up of £12.00 from HMRC while Employee B pays £60 into the pension and pays £12.00 less tax as a result.
On the face of it, it might look like it doesn’t make a difference to employees if a pension scheme uses “relief at source” or “net pay arrangement”. However, for low earners who earn above the auto enrolment trigger (£10,000.00 per annum or £833.33 per month) but at or below the normal tax threshold (£11,850.00 per annum or £987.50 per month for 2018/19), a “relief at source” pension scheme is a better option than a “net pay arrangement” one.
As an example, let’s take 2 employees on £950.00 per month and same tax code of 1185L M1 (tax-free allowance of £987.50 per month). Again, we will assume that pension contributions are paid on all gross earnings.
For Employee A who is in a “relief at source” pension scheme, pension contributions via payroll would be £22.80 i.e. £950.00 x 2.4% (i.e. 80% of 3%) and £5.70 would be topped up by HMRC. Total amount in the employee’s pension pot would therefore be £28.50 (i.e. £22.80 plus £5.70). Because the earnings of £950 are below the tax-free allowance, the employee pays no tax and their take home pay is £927.20 (i.e. £950.00 - £22.80).
For Employee B who is in a “net pay arrangement” pension scheme, pension contributions would be £28.50 i.e. £950.00 x 3%. Since the earnings are below the tax-free allowance threshold anyway, there is no tax to pay. The take home pay however is £921.50 (i.e. £950.00 - £28.50), which is lower than that for Employee A.
Because of this anomaly between the 2 types of tax relief for low income earners, there are growing calls on the government to change the rules to make it fair for everyone.
Whether you have one employee or several, managing employee holidays can prove to be an admin hassle. Here are a few tips that might help ease the admin burden.
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One of the areas that we frequently get asked about by our clients is in relation to tax codes and how tax has been calculated for a particular employee. Providing a clear and concise breakdown of the tax calculation is something that we do on a regular basis. If you are puzzled by the numbers and letters in your tax code, below is a brief and simple guide to help you understand what your tax code means.
Broadly speaking, there are 2 types of tax code: cumulative and non-cumulative.
An example of a cumulative tax code is 1185L.
An example of a non-cumulative tax code is 1185L W1 or 1185L M1 or 1185L W1/M1 or 1185L X.
Cumulative tax codes calculate the tax due in the current pay period as the difference between the total tax due to date and the total tax paid up to the last pay period. As you will note from this, it is possible to get a negative difference if the total tax due to date is less than the total tax deducted up to the last pay period. This could be the case for example where an employee has received a bonus in the last pay period which results in more tax being deducted in that pay period than normal, or if an employee has had a gap in their employment. In this situation, the employee would receive a tax refund via payroll.
Non-cumulative tax codes are also known as Emergency Tax Codes. Non-cumulative tax codes calculate the tax to be deducted in each pay period by taking into account only those taxable earnings for that pay period.
The amount that an employee gets as their tax-free personal allowance is determined by the numbers that make up the tax code and also the letter that precedes or supersedes those numbers. If the tax code is made up of numbers followed by the letters L, M, N or T, multiplying the number by 10 will give you the total tax-free personal allowance for the tax year. Multiplying the tax code number by 10 and then dividing that by the number of pay periods (52 for weekly, 12 for monthly) will give you the tax-free personal allowance per pay period. Each tax year, HMRC will update the standard tax-free personal allowance. For the 2018/19 tax year, the standard tax-free personal allowance is £11,850 so most employees will end up with a tax code of 1185L. HMRC will adjust the tax code to collect more tax by reducing the value of the tax-free personal allowance. If HMRC need to collect tax on things like Benefits In Kind and the value of these is such that they are more than the value of the tax-free personal allowance, they will issue a K tax code (tax code with a K prefix). This tax code has a negative tax-free personal allowance which means that tax is calculated on all earnings (no tax-free personal allowance) as well as an additional amount determined by the value shown after the letter K.
What to do if you think your tax code is wrong
It is always a good idea to regularly check the tax code shown on your payslip. Remember, the lower the number shown before the letter in your tax code, the more tax you will pay. HMRC will issue revised tax codes from time to time and they are supposed to write to the employee to let them know that their tax code has been revised. At the same time, they will also issue a coding notice to the employer instructing them of the change. The coding notice that is issued to the employer will never tell the employer how the tax code has been worked out. If you think that your tax code is incorrect, you can use the HMRC Personal Tax Account service (https://www.gov.uk/check-income-tax-current-year). You will need to create an account first if this is your first time using the service. Alternatively, you can also contact HMRC on 0300 200 3300, making sure that you have your National Insurance number to hand.