Knowledge Hub
Income Tax: A Complete Payroll Guide
Your complete guide to how income tax works through payroll, covering everything from PAYE and tax codes to the trickier situations like overpayments.
In brief:
PAYE is how employers deduct income tax and National Insurance from wages are paid every payroll period, then report and pay this to HM Revenue and Customs (HMRC) each pay month.
For 2026/27, most UK employees pay no tax on the first £12,570 of earnings, 20% on income up to £50,270, 40% up to £125,140, and 45% above that per annum—Scotland has its own six-band system with rates up to 48%, so Scottish employees’ deductions won’t match the rest of the UK.
A tax code tells you how much of an employee’s pay is tax-free (before deductions start), and an incorrect one—common with new starters or emergency codes—can quietly cause over- or underpayments that need correcting later.
Tax touches every payroll run you make, and getting it right means understanding more than just the headline rates. This guide covers how income tax is deducted through PAYE, what the 2026/27 rates and thresholds look like (including Scotland’s separate rates), and looks into questions like ‘how do tax codes work?’, ‘what to do when something out of the ordinary lands?’ (think a backdated pay rise, an emergency tax code, or an overpayment that needs correcting), and’ how do National Insurance, student loans, and benefits in kind fit alongside income tax in your payroll?’.
Whether you’re running payroll in-house or just want to understand what’s being deducted from your people’s wages and why, you’ll find clear, practical explanations throughout.
What is PAYE?
PAYE (Pay As You Earn) is the system where income tax and National Insurance contributions are automatically deducted from your people’s salary or pension before they receive it.
How does PAYE work?
PAYE is the main way income tax and National Insurance are collected from employees in the UK. As the employer, you calculate how much tax is owed based on each person’s earnings and tax code, then deduct it from their wages before they’re paid. (Pension providers do the same when they pay out a pension.)
The advantage of the system is that it’s handled as you go. You report and pay these deductions directly to HMRC each pay period, so neither you nor your people need to settle a separate tax bill at year-end for income taxed under PAYE. Your job is making sure the figures going in—earnings, tax codes, start and leaver dates—are right, because everything in your payroll later depends on them.
Tax rates and personal allowance
For 2026/27, income tax rates and bands in England, Wales, and Northern Ireland remain unchanged. The thresholds are frozen until April 2031. These bands apply after the Personal Allowance, the £12,570 most people can earn tax-free, which reduces by £1 for every £2 earned over £100,000. Only the portion of income within each band is taxed at that rate.
Income tax rates
For 2026/27, income tax rates and bands in England, Wales, and Northern Ireland remain unchanged. The thresholds are frozen until April 2031.
| Tax band | Earnings (after personal allowance) | Tax rate |
|---|---|---|
| Basic rate | Up to £37,700 | 20% |
| Higher rate | From £37,701 to £125,140 | 40% |
| Additional rate | Above £125,140 | 45% |
Source: GOV.UK, Rates and thresholds for employers 2026 to 2027. Checked 29 July 2026.
Scotland has its own income tax rates for non-savings, non-dividend income. For 2026/27, the Scottish Government increased the Starter rate band limit by 40.3% and the Basic rate band limit by 13.6%, pushing the entry points for the Basic and Intermediate rates up by 7.4%. The Higher, Advanced, and Top-rate thresholds remain frozen.
The income tax rates in Scotland for 2026/27 are:
| Tax band | Earnings (after personal allowance) | Tax rate |
|---|---|---|
| Starter rate | Up to £3,967 | 19% |
| Basic rate | £3,968 to £16,956 | 20% |
| Intermediate rate | £16,957 to £31,092 | 21% |
| Higher rate | £31,093 to £62,430 | 42% |
| Advanced rate | £62,431 to £125,140 | 45% |
| Top rate | Above £125,140 | 48% |
Source: GOV.UK, Rates and thresholds for employers 2026 to 2027. Checked 29 July 2026.
Note: Scottish taxpayers pay the same UK rates on savings and dividend income.
Get the latest insights and best practice guides, direct to your inbox.
What is a tax code?
In the UK, a tax code is a combination of numbers and letters issued by HMRC to determine how much income tax should be deducted from an individual’s salary or pension.
It reflects a person’s tax-free allowance and any adjustments for benefits, deductions, or additional income. Employers and pension providers use the tax code to calculate the correct amount of tax to deduct.
These are a list of UK tax codes and what they mean:
| Tax code | What they mean | Explanation |
|---|---|---|
| L | Standard personal allowance | Entitled to the standard tax-free personal allowance. |
| M | Marriage allowance | Received a transfer of 10% of a partner’s personal allowance. |
| N | Marriage allowance | Transferred 10% of their personal allowance to a partner. |
| T | Other calculations involved | Includes other calculations (such as company benefits) to determine the personal allowance. |
| 0T | No personal allowance or emergency code | The personal allowance has been used up, you’re missing employee details, or they have just started a new job. |
| BR | Basic rate tax code | All income from this job or pension is taxed at the basic rate (usually used if an employee has more than one job or pension). |
| D0 | Higher rate tax code | All income from this job or pension is taxed at the higher rate likely because of an additional job or pension. |
| D1 | Additional rate tax code | All income from this job or pension is taxed at the additional rate. |
| NT | No tax | No tax is paid on this income. |
| K | Income exceeding allowance | For income that isn’t being taxed elsewhere and is worth more than the tax-free Personal Allowance (such as unpaid tax from a previous year or taxable company benefits). |
Source: GOV.UK, Tax codes: what your tax code means. Checked 29 July 2026.
If HMRC has an employee’s main residence recorded as Scotland, you’ll see an S-prefix code instead, and it’s worth knowing what each one means since the bands underneath are different too.
| Tax code | What they mean | Explanation |
|---|---|---|
| S1257L | Standard personal allowance, Scottish rates | Main residence recorded as Scotland; the same allowance as 1257L, but taxed across the six Scottish bands. |
| S0T | No allowance, Scottish rates | Allowance used up, or a Scottish starter with no P45. |
| SBR | Scottish basic rate, no allowance | Second job or pension, taxed at 20% throughout. |
| SD0 | Scottish intermediate rate, no allowance | Second job or pension, taxed at 21% throughout. |
| SD1 | Scottish higher rate, no allowance | Second job or pension, taxed at 42% throughout. |
| SD2 | Scottish advanced rate, no allowance | Second job or pension, taxed at 45% throughout. |
| SD3 | Scottish top rate, no allowance | Second job or pension, taxed at 48% throughout. |
Source: HMRC internal manual, PAYE11025 — P2 notes for codes with no allowances or deductions. Checked 29 July 2026.
Emergency tax
An emergency tax code is a temporary code that HMRC applies when there isn’t enough information to determine an employee’s correct code. You’ll see it most often with new starters—someone who’s just moved from self-employment, started receiving a company pension, or hasn’t handed over a P45 yet.
Even when a new starter checklist has been completed, it quite often results in a tax code that’s itself an emergency code, just a temporary one while HMRC gets the full picture. So a completed checklist doesn’t rule out emergency tax; it’s more about giving HMRC (and you) enough to work with while the correct code is sorted.
You’ll spot an emergency code on payroll as W1, M1, or X, often sitting alongside the standard 1257L. While it’s in place, the tax is calculated for that pay period alone rather than over the year, so the employee may pay a little too much (or occasionally too little) for a while.
The good news is that it’s usually temporary. Once HMRC has the right details—either from you or from the employee—the code is updated, and any over-deduction is corrected, often automatically through PAYE. The main thing on your side is making sure new starter checklists are completed promptly and accurately.
Related payroll deductions and tax interactions
Payroll is the source of truth for multiple statutory reports running simultaneously. The same underlying figures flow into multiple obligations at the same time. Understanding these dependencies is what separates organisations that manage statutory payroll reporting well from those that discover problems after the fact.
National Insurance
National Insurance contributions (NICs) sit alongside income tax in every payroll run, but they work differently. Your people pay primary Class 1 NICs on their earnings, while you, as the employer, pay secondary Class 1 NICs on top of wages—a real cost to the organisation rather than a deduction from pay. Both are worked out through PAYE and paid to HMRC alongside your income tax deductions, though unlike income tax, National Insurance is calculated per pay period rather than cumulatively over the year, so a one-off spike in earnings can push contributions up for that pay run alone.
The rates themselves are straightforward, even if the mechanics around them aren’t. Employees pay primary Class 1 NICs at 8% on earnings between the Primary Threshold and the Upper Earnings Limit, dropping to 2% on anything above it. As the employer, you pay secondary Class 1 NICs at 15% on earnings above the Secondary Threshold—there’s no upper limit on your side, so it applies to the whole of an employee’s earnings above that point, not just a band.
These rates are frozen for 2026/27, so if you’ve got them right this year, you shouldn’t need to touch them again come April.
Benefits in kind
A benefit in kind is anything you give an employee alongside their salary that has a monetary value—a company car, private medical insurance, or gym membership, for example. It’s not cash, but HMRC still wants tax on it: the employee pays income tax on the value, either through their tax code or via payrolling, and you, as the employer, pay Class 1A National Insurance at 15% on top. Whether you report benefits on a P11D or payroll them through the year changes the admin involved, and that choice is narrowing anyway, since payrolling the most common benefits-in-kind becomes mandatory in phases from April 2027.
PAYE Settlement Agreements
If you’d rather not run every minor benefit through individual payslips, a PAYE Settlement Agreement (PSA) lets you settle the tax on certain benefits in one annual payment instead. It’s designed for things that are minor, irregular, or genuinely impractical to value per employee, like staff entertaining and small gifts are the usual candidates. It won’t suit every benefit, but it can save a fair bit of admin on the ones it does cover.
How do pension contributions affect tax?
Auto-enrolment pensions sit alongside PAYE, but how a scheme is set up changes what actually gets taxed. This is worth knowing as two people on the same salary can end up with different taxable pay depending on their pension arrangement.
Contributions come off gross pay before tax is worked out, so taxable pay is reduced and tax relief is given automatically at the employee's own rate.
Contributions come off pay after tax, and the pension provider claims back basic rate relief directly from HMRC. Higher and additional rate taxpayers need to claim the rest of their relief themselves through Self Assessment or by contacting HMRC.
The employee gives up part of their salary in exchange for a pension contribution, which lowers gross pay itself before tax is calculated at all, rather than being treated as a deduction from pay.
This works well for reducing an employee’s taxable pay, but be aware that salary sacrifice needs checking against National Minimum Wage before it’s set up.
Student loan deductions
If one of your people is repaying a student loan, you’re usually the one collecting it, through payroll, alongside tax and NICs. HMRC tells you when to start and stop deductions by sending a start notice or stop notice, and repayments are calculated per pay period at a rate set by the employee’s plan type. Someone can be on more than one plan at once, so it’s worth checking the start notice carefully when you set them up
What's the difference between taxable and non-taxable pay?
Not every pound your people earn is treated the same way by HMRC. Once allowances and reliefs have been applied, most income falls into the taxable pool — salary, benefits, pension income, and more all sit here. But a handful of specific allowances and account types are carved out entirely, meaning no tax is due on them at all. Knowing where that line sits matters, since it’s easy to assume something’s taxable when it isn’t, or vice versa.
Taxable pay
Taxable income refers to the portion of pay that is subject to tax. This is after allowances and reliefs have been applied. This includes:
- Employment income: Salary, bonuses, and benefits in kind
- Self-employment profits: Earnings after allowable expenses
- Most pensions, including state pensions, company and personal pensions and retirement annuities
- Property income: Profits from letting property
- Investment income: Dividends and interest from savings or shares
Non-taxable pay
Non-taxable income, as the name suggests, covers certain benefits and allowances that don’t require a tax payment, like:
- the first £1,000 of income from self-employment, known as ‘trading allowance’
- the first £1,000 of income from any property you rent (unless you’re using the Rent a Room Scheme)
- income from tax-exempt accounts, like Individual Savings Accounts (ISAs) and National Savings Certificates
- dividends from company shares under your dividends allowance
- some state benefits
How tax reaches HMRC
Working out the right deductions is only half the job; you also have to report them. This happens through Real Time Information (RTI), and it’s the mechanism that ties most of your tax obligations together.
RTI submissions
Every payday, you send HMRC a Full Payment Submission (FPS) reporting what you’ve paid and what you’ve deducted. Where needed, an Employer Payment Summary (EPS) adjusts what HMRC expects to receive—for example, to claim Employment Allowance or reclaim statutory payments.
For the detail on how this works, see our overview of Real Time Information.
Year-end
After the tax year closes, you issue a P60 to every employee still on payroll on 5 April (by 31 May) and report any non-payrolled benefits on a P11D by 6 July.
Missing these deadlines incurs penalties, so it’s worth adding them to a year-end checklist.
Record keeping and tax
Whatever else changes year to year, the record-keeping requirement doesn’t move: you need to keep PAYE records for three years after the end of the tax year they relate to. That covers what you paid and deducted, your reports and payments to HMRC, tax code notices, and details of any taxable expenses and benefits.
The good news is that this is one of the more predictable compliance obligations you’ll deal with—but be aware that HMRC can inspect these records at any time within that period, and if they’re incomplete or inadequate, you could face a penalty of up to £3,000. It’s worth building a routine check into your year-end process, rather than assuming everything’s been filed away correctly as you go.
If records are ever lost, stolen or destroyed, make sure to tell HMRC as soon as you can, rebuild what you’re able to from other sources (bank statements, pension provider records, and so on), and flag clearly any figure in your next Full Payment Submission that’s an estimate rather than a confirmed number.
Getting income tax right, every payday
Income tax through payroll is rarely difficult in principle, but a frozen threshold left un-updated, a benefit not run through payroll, or an emergency code left uncorrected can lead to penalty letters or unhappy employees. The organisations that handle it well aren’t the ones who try hardest at year-end—they’re the ones whose systems keep the data clean year-round.
That’s where the right software earns its place. Cintra’s payroll and HR software calculates income tax, NICs, and student loan deductions accurately each pay period, submits FPS and EPS directly to HMRC, and generates your P60s and P11Ds from live payroll data, so the figures feeding every obligation stay consistent.
If you’d like to see how it works, we’d be happy to walk you through it with a live demo with a member of our team.
Frequently Asked Questions
Q. How does income tax work through payroll?
A. Income tax is deducted from an employee's pay by their employer each time they're paid, using PAYE (Pay As You Earn). The employer works out how much tax is owed based on the employee's earnings and tax code, deducts it before paying the employee, and reports and pays it to HMRC. This means most employees never need to settle a separate tax bill at year-end.
Q. What tax code should a new employee be on?
A.
It depends on the information they give you. With a P45 or a completed starter checklist, you'll usually apply the standard code (1257L for 2026/27). Without enough detail, HMRC may apply an emergency code (W1, M1, or X) until the right information comes through.
Q. What's the difference between a net pay arrangement and salary sacrifice for Income Tax purposes?
A. Under a net pay arrangement, pension contributions come off gross pay before Income Tax is worked out, so taxable pay is reduced. Under salary sacrifice, the employee gives up part of their salary in exchange for a pension contribution, which lowers gross pay itself rather than being treated as a separate deduction. Both reduce the amount of Income Tax paid, just through a different mechanism.
Q. Do higher rate taxpayers get full tax relief on pension contributions automatically?
A. Not always. Under a net pay arrangement, relief happens automatically at the employee's own rate. Under relief at source, the pension provider only claims back basic rate relief directly from HMRC, so higher and additional rate taxpayers need to claim the rest of their relief themselves, usually through Self Assessment.
Q. What is a PAYE Settlement Arrangement (PSA)?
A. A PAYE Settlement Agreement (PSA) lets an employer settle the Income Tax on certain employee benefits in one annual payment to HMRC, rather than reporting them individually per employee through payroll or a P11D. It's designed for benefits that are minor, irregular, or impractical to value separately, such as staff entertaining or small gifts.
Q. What is an S tax code and how does it affect Income Tax?
A. An S tax code (for example S1257L) means HMRC has recorded an employee's main residence as Scotland, so their Income Tax is calculated using Scotland's six-band system— 19% to 48%—instead of the three-band system used in England, Wales and Northern Ireland. It follows where an employee lives, not where they work, and only Income Tax differs; National Insurance stays the same UK-wide.
Income tax doesn't have to be confusing, we've got you covered.
With Cintra, you can put the guesswork aside and get income tax right, first time, every time. From automatic tax code updates to clear reporting on every payslip, you have everything you need to stay compliant and keep your people paid correctly.
