How PAYE deducts tax from pay as it is earned, what changes a tax code during the year, how refunds and underpayments are settled, and how the P45, P60 and starter checklist fit together.
Primary source: Tax codes (GOV.UK).
Pay As You Earn spreads a taxpayer's allowance across the year rather than applying it all at once. Each pay period carries a slice of the annual allowance, and tax is calculated on the pay above that slice. Because the allowance is applied cumulatively, an over- or under-deduction in one month corrects itself over the rest of the year.
The mechanism is the tax code. A code such as 1257L tells the employer how much tax-free pay the employee is entitled to across the year. The number is the allowance divided by ten, so 1257L corresponds to an allowance of £12,570. The letter that follows says how that allowance should be applied.
A code is not fixed for the year. HMRC recalculates it whenever the information behind it changes, and the employer applies the new code from the next payroll run. The most common triggers are a change of job, a new benefit in kind, untaxed income such as savings interest, or a correction to an earlier year.
When an employer has no P45 and no code from HMRC, a temporary code is applied so that pay is taxed rather than left untaxed. It is replaced once HMRC issues the correct code, and any over-deduction is corrected through the cumulative calculation.
Because PAYE is cumulative, most corrections are absorbed inside the year. If too much tax has been deducted, the employee usually sees a smaller deduction in a later payslip rather than a separate refund. If too little has been deducted, the shortfall is collected by reducing the tax-free amount in a later code.
Where the tax year has already ended, HMRC reconciles the year against the records it holds and issues a calculation. A refund can be paid directly, and an underpayment can be collected through a future code or, for larger amounts, through Self Assessment.
A P45 is issued when a job ends. It shows pay and tax to date for that employment, and the next employer uses it to continue the cumulative record. A P60 is issued by the employer after the tax year ends and is the final statement of pay and tax for the whole year. A starter checklist is used when a new employee has no P45, and the employee's answers tell the employer which temporary code to apply until HMRC issues the correct one.
The Personal Allowance can only be used once. Where a taxpayer has two jobs, HMRC normally puts the allowance against the main employment and applies a code that taxes the second income without an allowance. A bonus is pay for PAYE purposes and is taxed in the period it is paid, though the cumulative calculation corrects the position in later periods.
Statutory redundancy pay is not taxed as earnings, while pay in lieu of notice and any contractual redundancy payment are taxed through PAYE as earnings. The two parts are separated on the payslip and in the P45.
A benefit in kind is a non-cash reward — a company car, private medical insurance, a low-interest loan — that has a taxable value. HMRC adds that value to the taxpayer's income, and the tax is collected by reducing the tax-free amount in the code. Where the benefit is payrolled by the employer, the tax is deducted through payroll directly and no code adjustment is needed.