How the Pay As You Earn system works

Pay As You Earn (PAYE) is HM Revenue and Customs’ system to collect income tax (which helps pay for services like education and healthcare), and National Insurance (which helps pay for some benefits and the State Pension) from employees.

On this page we tell you more about how PAYE tax and National Insurance deductions work. For most employers, their PAYE deductions will be handled by their payroll software. Even those who are running their payroll manually can access help in the form of PAYE tax and National Insurance calculators.

Nevertheless, if you want to run your own payroll, it will certainly help to have a basic understanding of the PAYE system – so that you can spot errors or so that you can check your employees’ payslips.

'Pay' for tax and National Insurance purposes
Tax under the PAYE system
National Insurance under the PAYE system
National Insurance for those aged under 21 years old and apprentices under 25
Employing your spouse or close relative – treatment for National Insurance purposes
£3,000 National Insurance Employment Allowance for employers          
          Background
          Who can claim?
          How does it work?
          How do employers claim it?
          Can I claim the £3,000 allowance after the tax year has started?
          Where can I find more information on Employment Allowance?

What else does the PAYE system collect?

‘Pay’ for Tax and National Insurance purposes

The PAYE regime requires tax and National Insurance to be deducted from most payments made by employers to employees.

To be able to operate PAYE correctly, you must therefore understand the main things that count as ‘pay’ for tax and National Insurance contributions (NIC) purposes (pay for the purpose of NIC’s is broadly the same as pay for tax although there are some differences). See our guidance on ‘pay and deductions’ for more information.

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Tax under the PAYE system

Where a person is employed, the employer will deduct income tax from their wages and pay it to HMRC under the PAYE system. A tax code is used by an employer to calculate the amount of tax to deduct from an employee’s pay. A tax code is normally made up of numbers and letters for example 1185L or K396.

Under the PAYE system, an employee’s personal allowance (the amount they are allowed to earn before they pay tax – £11,850 in 2018/19) is allocated evenly throughout the year. HMRC uses a tax code to tell an employer what tax free earnings an employee is entitled to in a particular pay period, so that tax at the appropriate rates may be calculated on the balance. This may be the personal allowance amount of £11,850 or it may be higher or lower, depending on their exact circumstances.

The more a person earns, the higher the amount of income tax they pay. You can see the key rates of income tax and personal allowances on GOV.UK.

PAYE spreads an employee’s income tax bill over the tax year (which starts on 6 April of one year and ends on 5 April in the next) rather than paying tax in one lump sum. It is important to understand that PAYE is not an exact measurement of an employee’s tax liability; rather it is an estimate of the tax that the employee should pay based on HMRC’s understanding of the income that they will receive.

You can see an example of how this works by looking at ‘Jenny’ below. We explain more about the way tax codes work here.

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National Insurance under the PAYE system

If you employ a PA, as well as collecting and sending the right amount of tax to HMRC, you will also need to collect and send NIC to HMRC.

NICs are paid to build up entitlement to certain state benefits, including the State Pension

Contributions are based on a percentage of earnings. Both employees and employers usually make payments. NIC payments made by employees are called primary Class 1 contributions and those made by employers are called secondary Class 1 contributions. 

For 2018/19, employees do not pay NIC on pay up to the threshold of £162 per week. However between £116 per week and this threshold, employees will receive credits on their National Insurance record which help protect entitlement to the State Pension and other benefits.

This is one of the reasons why employers are always required to record and report information about employees who earn at least £116 per week under the PAYE system, even if no money actually needs to be sent to HMRC – so that HMRC can see that they need to put NIC credits on the employee’s record.

For 2018/19, employers are supposed to pay NIC on any employee’s pay over £162 per week. You can see the key rates of NIC on GOV.UK. However because most employers can get up to £3,000 a year off their National Insurance bill, there may not actually be any employer’s NIC to pay.  We explain more in our section on the Employment Allowance.

It is important to note that unlike tax, which is calculated cumulatively (i.e. by looking at what has happened in the tax year so far), National Insurance is calculated by looking at employee’s earnings, whether paid weekly or monthly, in isolation, on each payday.

Example:

Jenny has two part time jobs. They both pay her £250 a week. Jenny’s tax free personal allowance (weekly amount of £228) is allocated against her first job through the payroll, 20% tax is deducted on every pound from her second job in accordance with code BR. Her weekly tax deductions in 2018/19 are therefore: Job 1: £4.40 (£250 - £228 = £22 x 20%), Job 2: £50.

At the end of the tax year, we can see that Jenny has paid more or less the right amount of tax, taking into account that her tax free personal allowance for the year is £11,850.

Income from first job

£13,000

Income from second job

£13,000

Total income

£26,000

Less personal allowance

(£11,850)

Balance subject to 20% tax

£14,150

Tax due

£2,830

The tax collected through the payroll for job 1 is £4.40 x 52 = £228.80

The tax collected through the payroll for job 2 is £50 x 52 = £2,600

Total collected = £2,828.80

For NIC purposes, in both her jobs, she will pay £10.56 a week, so a total of £21.12 per week and an amount of £1,098.24 annually. The weekly amount is calculated as £250 - £162 = £88 x 12% = £10.56. The fact she is working two jobs is not taken into consideration for NIC like it is for tax. Her NIC liabilities for her two jobs are calculated totally independently from each other and are not compared to an overall annual amount, like for tax.

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National Insurance for those aged under 21 years old and apprentices under 25

Employers with employees under 21 years old do not have to pay Class 1 secondary contributions (i.e. the employers contribution), providing the earnings are less than £46,350 per annum (£892 per week).

The employee will continue to pay National insurance at the usual rates – so this is a benefit only to the employer.

Full details of the scheme can be found on the GOV.UK website.

A similar provision applies to apprentices under 25. Full details of the scheme can be found on the GOV.UK website.

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Employing your spouse or close relative – treatment for National Insurance purposes

It is important that you are aware that there are no special tax rules that apply to employing members of your family. The same tax rules apply to family members as they do to any other employees.

However, for NIC purposes if you employ someone you usually live with in the same ‘dwelling house’ then this will be disregarded and no NIC will be payable. We explain more about this in our ‘employing a family member’ section here.

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£3,000 National Insurance Employment Allowance for employers

In 2018/19, you can get up to £3,000 a year off your National Insurance bill if you’re a care and support employer.

Background

In April 2014, the government introduced an 'Employment Allowance' (originally £2,000 per year) for employers to offset against their employer NIC liability. This was not initially open to care and support employers.

From April 2015, the scheme was extended to cover individuals employing certain care and support workers. 

Employers of other domestic staff (such as chauffeurs, gardeners, nannies) are still excluded from having the allowance because the Government’s aim for the allowance is to support businesses aspiring to grow by hiring their first employee or expanding their workforce. It is therefore aimed at commercial enterprise, rather than personal domestic service.

Who can claim?

If an employer is paying an employee who is a care and support worker more than £162 per week in 2018/19 (and so is liable for employer's NIC at 13.8% on the excess of the weekly pay over this threshold), they could be entitled to the Employment Allowance, provided:

  1. The employee is caring for either the employer or a friend or relative of the employer;
  2. The individual needs care because of their old age, mental or physical disability, past or present dependence on alcohol or drugs, past or present illness, or past or present mental disorder;
  3. The employee’s duties of the employment relate wholly to providing the care to the individual who needs it.

It is irrelevant whether the employer funds the cost of employing a PA from direct payments (or other Government funding) or whether it is from personal resources.

Employers with PA’s under 21 or apprentices under 25 do not need to pay employer’s NIC anyway, so do not need to claim the Employment Allowance.

How does it work?

The allowance is given as a credit to reduce the employer’s National Insurance contributions actually payable, up to a maximum of £3,000 over the whole tax year. This means a care and support employer could pay their carer, or carers anything up to about £580 per week in total in 2018/19 (around £30,160 per annum), and will have no employers NIC to pay as the liability comes under the £3,000 allowance. By comparison an employee paid £600 a week in 2018/19 will generate an employer’s NIC liability of £3,143.08. Under the Employment Allowance, the first £3,000 can be deducted, leaving £143.08 payable for the tax year.

Note that any employer’s NIC above £3,000 will only be paid once the Employment Allowance has been exhausted, so in the example above you would pay over no employer’s NIC for the first 11 ‘payment’ months of the tax year (or first three quarters if you are a quarterly payer) and £143.08 in the twelfth month (or in the final quarter).

How do employers claim it?

If you file HMRC returns online: the Employment Allowance is usually claimed on an Employer Payment Summary (EPS) which you should submit at the beginning of the tax year, or when you take on your first employee if later (your payroll software might prompt you to do this). You simply tick the box in your payroll software which confirms you are eligible and the Employment Allowance will be applied automatically to reduce your employer's NIC bill.

If you use HMRC’s Basic PAYE Tools (BPT) software, then you will find the box to tick in the Employer details section – select ‘Change employer details’. 

You should be aware that you must send in an EPS to tell HMRC that the allowance is being claimed. If you simply do things as usual, but reduce the amount that you pay to HMRC by the allowance, this will flag as an underpayment on their systems and it is likely you will be contacted by HMRC. Please also note you only need to tick the relevant box once to make HMRC aware you are claiming the Employment Allowance – this will then apply it on an ongoing basis. You should not untick the box when the Employment Allowance has been fully used.

You file your HMRC returns on paper: tick the box which asks whether the Employment Allowance is to be claimed on page 2 of the form RT5. You need to remember to subtract the value of the allowance from your employer's NIC liability before you make an actual payment to HMRC.

For more information on claiming the Employment Allowance see booklet RT7 – Guidance for employers exempt from filing Real Time Information online.

Can I claim the £3,000 allowance after the tax year has started?

Yes. If claiming it late means that you will not have used the maximum amount of Employment Allowance allowable, HMRC will offset the balance against another PAYE liability or refund you, so the allowance is not lost.

Example: 

You pay your PA £275 per week, however you only realise in week 10 that you can claim the Employment Allowance, rather than doing so from week 1. The Employment Allowance will therefore be applied from week 10 – it cannot be backdated to week 1. This means that although you will not pay any Employer’s NIC from week 10 onwards, you will have paid £15.59 NIC in each of weeks 1 to 9 that strictly you did not need to. At the end of the tax year HMRC will therefore give you a credit for £140.34 (£15.59 x 9) to use against other PAYE liabilities (or will refund you the amount if you have nothing to use it against).

Where can I find more information on the Employment Allowance?

  • Guidance on the Employment Allowance can be found on GOV.UK.
  • Detailed guidance on care and support worker eligibility for the Employment Allowance and how to claim is available here.

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What else does the PAYE system collect?

As well as collecting income tax and National Insurance, the PAYE system is used to collect things like Student Loan repayments and the Apprenticeship Levy.

The Apprenticeship Levy, which is payable by certain employers from 6 April 2017, is charged at a rate of 0.5% of an employer’s annual pay bill.

A £15,000 annual allowance for employers means that the levy is only paid by employers whose annual pay bills exceed £3m - so it will probably not be relevant to care and support employers.

Based on current HMRC guidance, it is our understanding that only employers who have an Apprenticeship Levy liability must report it under the PAYE system i.e. the system assumes that the £15,000 allowance applies, unless you tell it otherwise. This is opposed to you having to do something to ‘opt-out’ which was a concern we outlined in a press release.

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