For a fair proportion of contractors, getting an emergency tax code will stir memories of moving from one permanent job to another or branching out as their own boss and adopting a new contract with a different trading vehicle. These experiences commonly boil down to one thing: exorbitant tax for the first month of three and drastically slashing take-home pay. But that isn’t an inevitability.
The financial strain of an emergency tax code can be avoided. A good authority for advice in this area is Derek Kelly, technical director of leading umbrella company Parasol who is personally responsible for overseeing the correct payment of a walloping 20,000 contractors every year.
Kelly believes that all it takes to nip the emergency tax code nightmare in the bud is a little planning and safe filing of paperwork between contracts on the part of contractors. That guarantees that they’ll commence work with an umbrella firm with the right tax code, sparing themselves any financial distress in the process.
Essentially, tax codes are designed to help HM Revenue and Customs sustain a healthy cash flow. They’re based on tax-free allowances, which permit everyone to earn a certain amount of income before taxation kicks in. At present in the UK, the upper limit of the tax-free personal allowance is £11,850, but it tends to change from one year to the next.
Because most people get paid on a monthly or weekly basis, the convention is to spread an umbrella contractor’s tax-free allowance over the financial year, meaning that he or she can earn 1/12th of their tax-free allowance each month before taxation starts (1/52 if they’re paid on a weekly basis). Above that, income tax is liable on their earnings for the month, payable on a PAYE basis (which means that it’s deducted at source by the employer).
Things become more complicated when employees receive certain benefits, such as a company car or private health insurance. If, for instance, the health insurance amounts to £500 per annum, it will be spread over the 12-month period. The tax code is amended to accommodate the benefit.
Kelly explains it like this: “The key issue, and where many contractors come unstuck, is that PAYE is cumulative. That means if they don’t have their P45 from a previous employer, they will automatically be placed on an emergency tax code, which is the same for everyone and is based on the tax-free earnings allowance.”
Holding a current P45 is the key to avoiding emergency tax codes. This document shows how much in earnings and income tax have been accrued to date by the contractor and contains his or her previous tax code which can be readily used by the umbrella company.
P45s are issued automatically to contractors by their previous employer at the point when they leave that employment. A copy is simultaneously passed on to HMRC. But it’s all too easy to mislay a P45. And it’s not unheard of for organisations to be somewhat careless in providing former employees with the correct, current paperwork.
A P45 should also be issued, usually by an accountant, to a contractor who moves from a limited company to an umbrella company, even when the only income has been a dividend (in which case no PAYE will have been accrued).
For contractors, P45s are precious documents. Keep them safe and know where you can lay your hands on them when needed.
Kelly again: “When a contractor starts working for Parasol without a P45, they are placed on an emergency tax code, which generally results in them paying more tax than they should. We immediately ask them to complete a P46, which we send to HMRC, who generate the new tax code, generally within three to four weeks.”
As soon as the right tax code is applied, the contractor will be reimbursed the excess emergency tax which is usually paid as a lump sum in the next payment period. Kelly notes that the Revenue is generally highly efficient at prioritising tax codes and instating rebates. The contractor will typically receive the full amount in a single payment rather than recouping it month by month through an adjusted tax code.
That means that the initial shock of a painfully lower net income is succeeded by a welcome “surprise” in the form of a lump sum from the taxman.
Contractors who are just beginning their freelance careers and have never worked previously in any capacity must apply for a tax code, as they will have no income tax history with the Revenue. Unfortunately, that does entail enduring an emergency tax code for the first few weeks, but they can rest assured that it will generally be reimbursed as quickly as administratively possible.
Contractors who have a gap in their employment or are between contracts and have no P45 can still apply for a tax code prior to commencing work with an umbrella company. As Kelly puts it: “In the weeks before they know they will be starting a new contract, the contractor can apply to HMRC directly for a tax code, and this will generally only take a few weeks to arrive.”
If a contractor can plan ahead like this, he’ll start working on the right tax code from the very first day and won’t overpay income tax by a single penny.