How to calculate payroll tax and national insurance
Under HMRC’s Making Tax Digital (MTD) regime, all payroll must be completed electronically using MTD approved accounting and payroll software. This makes running payroll easier and less prone to calculation errors. One of the downsides of this is many people who run payroll don’t fully understand the calculations behind the figures. This may result in input or software errors being overlooked.
In this article, we explain how the core payroll deductions of PAYE, employer and employee national insurance contributions and workplace pension contributions are calculated.
Employee deductions
Calculating pay as you earn tax (PAYE)
The UK has a marginal tax system where income is taxed at the tax rate applicable to the tax band in which income falls. Marginal taxation means the tax system applies progressively higher tax rates to each additional band of income you earn, so you pay a low rate on your first portion of income, a higher rate on the next portion, and so on, rather than applying one flat rate to your entire income.
In England, income below the annual personal allowance of £12,570 is tax-free. The next £37,700 of income falls in the basic rate band tax band of 20% (up to £50,270). Income between £50,270 and £125,140 falls within the higher rate tax band of 40%, while income over the additional band threshold of £125,140 is taxed at 45%.
Tax bands
The table below provides details of the tax bands and rates.
| Tax band | Band range | Tax rates |
|---|---|---|
| Personal allowance | Up to £12,570 | 0% |
| Basic rate | £12,571 to £50,270 | 20% |
| Higher rate | £50,271 to £125,140 | 40% |
| Additional rate | Over £125,140 | 45% |
Personal allowance
In the UK, individuals benefit from a personal tax allowance of £12,570, which lets them earn up to this amount annually tax-free. The tax system deducts this personal allowance from your salary and taxes the remaining amount. In payroll software, the personal allowance is captured as a tax code (1257L), which tells the software how much you can earn tax-free.
Adjusted personal allowance
HMRC may adjust your personal allowance if you overpaid or underpaid tax in a previous tax year. Employees who receive additional taxable benefits, such as private medical insurance, may receive an adjusted tax code, whereby the payroll system collects tax on the benefit through your regular pay.
The personal allowance decreases by £1 for every £2 you earn over £100,000. Once you earn over £125,140, you lose the full personal allowance.
For individuals who do not have the standard tax code of 1257L or personal allowance of £12,570, their higher tax rate threshold is different to £50,270. The higher rate threshold is adjusted upwards or downwards depending on the tax code. For instance, someone with a tax code of 1000L has a reduced annual personal allowance of £10,000. Their income falls into the higher 40% rate tax band once it exceeds £47,700. (£10,000 plus £37,700). The additional 45% rate band is not affected by any adjustments to the personal allowance and remains at the £125,140 threshold.
PAYE is calculated cumulatively over the year
UK individuals pay tax based on their cumulative income to date. Payroll software calculates the personal allowance on a cumulative basis, then deducts it from the year to date income. For example, someone who only begins working in July will have 4 months of cumulative personal allowance to deduct from their year to date or July earnings.
- Assuming a monthly salary of £3,500 for July
- In July, they will have 4 months of personal allowance available, which is £4,190 (£1,047.50 x 4)
- Because their personal allowance exceeds their cumulative salary of £3,500 at the end of July, no tax is due.
- In August, their cumulative pay is £7,000 (2 x £3,500) and their cumulative personal allowance is £5,238 (£1,047.50)
- Deducting the cumulative personal allowance of £5,238 from the cumulative earnings of £7,500 leaves £1,738 of taxable income.
Examples of PAYE calculations for employee earnings
Someone earning £35,000 a year with the full personal allowance, with a tax code of 1257L:
| Salary breakdown | Tax band | Tax rate | Tax |
|---|---|---|---|
| £12,570 | Personal allowance | 0% | 0 |
| £22,430 | Basic rate band | 20% | £4,486 |
| £35,000 | £4,486 |
The figures for an employee earning £70,000 a year with a 1257L tax code:
| Salary breakdown | Tax band | Tax rate | Tax |
|---|---|---|---|
| £12,570 | Personal allowance | 0% | 0 |
| £37,700 | Basic rate band | 20% | £7,540 |
| £19,730 | Higher rate band | 40% | £7,892 |
| £70,000 | £15,432 |
And for an employee earning £110,000 with a reduced personal allowance of £7,570 the figures are:
| Salary breakdown | Tax band | Tax rate | Tax |
|---|---|---|---|
| £7,570 | Personal allowance | 0% | 0 |
| £37,700 | Basic rate band | 20% | £7,540 |
| £64,730 | Higher rate band | 40% | £25,892 |
| £110,000 | £33,432 |
Calculating employee national insurance
Employees pay national insurance of 8% on their earnings between £12,570 and £50,270. Employee’s national insurance is 2% on earnings over £50,270. National insurance contributions for both employees and employers are calculated on the monthly income and not on a cumulative basis like PAYE.
Using the examples above, the employees’ national insurance will be:
On an annual salary of £35,000:
| Salary breakdown | National insurance rate | NIC |
|---|---|---|
| £12,570 | 0% | 0% |
| £22,430 | 8% | £1,794 |
| £35,000 | £1,794 |
For an annual salary of £70,000:
| Salary breakdown | National insurance rate | NIC |
|---|---|---|
| £12,570 | 0% | 0% |
| £37,700 | 8% | £3,016 |
| £19,730 | 2% | £395 |
| £70,000 | £3,411 |
The figures for an annual salary of £110,000 are:
| Salary breakdown | National insurance rate | NIC |
|---|---|---|
| £12,570 | 0% | 0% |
| £37,700 | 8% | £3,016 |
| £59,730 | 2% | £1,195 |
| £110,000 | £4,211 |
Employer costs
Calculating employer national insurance contributions
Employers pay employer national insurance of 15% on employee salaries over £5,000 a year or £416 a month.
The chart below illustrates the annual employer NICs for the above examples:
| Annual salary | Salary for NIC | Employer NIC of 15% |
|---|---|---|
| £35,000 | £30,000 | £4,500 |
| £70,000 | £65,000 | £9,750 |
| £110,000 | £105,000 | £15,750 |
The chart below illustrates the monthly employers’ NICs for the above examples:
| Monthly salary | Salary for NIC | Employer NIC of 15% |
|---|---|---|
| £2,917 | £2,500 | £375 |
| £5,833 | £5,417 | £813 |
| £9167 | £8,750 | £1,313 |
Workplace pensions
Employer workplace pension contributions
Under automatic pension enrolment, employers must enrol employees in a workplace pension and contribute a minimum of 3% of their salary to the pension. Employers make contributions on employee salaries between the thresholds of £6,240 and £50,270.
Using the above examples again, with a salary of £35,000, the employer pension contributions are 3% of £28,760 (£35,000 less £6,240), which is £862.80 a year or £71.90 per month.
Both salaries salaries exceed the upper threshold of £50,270 in the other two examples, meaning employer contributions are 3% of £44,030 (£50,270 less £6,240). This is £1,321 yearly or £110 a month.
Employee workplace pension contributions
Employers and employees must together contribute at least 8% of earnings to a workplace pension. If the employer contributes the minimum 3%, the employee must contribute 5% of their salary on earnings between the £6,240 and £50,270 thresholds.
Employees receive 20% tax relief on pension contributions, which reduces their contribution from 5% to 4% of their salary.
On this basis, someone earning £35,000 a year will pay annual contributions of £1,150 with HMRC adding £287 in tax relief. Someone earning over the upper pension threshold of £50,270 will make yearly contributions of £1,761 with HMRC adding £440 to their pension.
Example illustrating the employer costs and employee payroll deductions
Assuming an annual salary of £40,000 and monthly salary of £3,333, the first table details the employer costs, whilst the second table shows the employee deductions.
| Employer Costs | Annual | Monthly |
|---|---|---|
| Salary | £40,000 | £3,333 |
| National insurance | £5,250 | £438 |
| Workplace pension | £1,013 | £84 |
| Total costs | £46,263 | £3,855 |
| Employee Deductions | Annual | Monthly |
|---|---|---|
| PAYE – Tax | £5,486 | £457 |
| National insurance | £2,194 | £183 |
| Workplace pension | £1,350 | £113 |
| Total deductions | £9,030 | £753 |
| Net pay | £30,970 | £2,580 |
You’ll find several financial calculators, including a net pay calculator and staff costs calculator, using the link below:
