PAYE (Pay As You Earn): The complete guide for business owners
As an employer, it’s your responsibility to correctly set up Pay As You Earn (PAYE) as part of your payroll. This is the process by which you will calculate and deduct the correct amount of income tax and National insurance from your employees’ wages and pay HM Revenue & Customs (HMRC).
If you don’t pay the correct amount to HMRC on or before payday each month, it could lead to penalty payments and interest charges.
Understanding PAYE and accurately managing it is essential to ensuring your business records are streamlined and you pay your staff the correct amount each pay cycle.
Table of contents
- What is PAYE?
- Setting up your PAYE payroll
- How is PAYE calculated
- How to report pay and deductions to HMRC
- Common PAYE pitfalls
- Wrapping up
What is PAYE?
PAYE is a system that enables employers to calculate and pay the correct amount of income tax and National Insurance to the government on behalf of their employees.
Through payroll processing, you will (either by yourself or through an HR specialist, accountant, or payroll provider) calculate the appropriate deductions and payroll benefits from your employees’ pay before they receive their payslips.
On their payslips, each employee will receive their net pay (which is their gross pay minus the total deductions). Because you automatically deduct income tax and National Insurance on their behalf, they don’t need to pay any further tax on their income thereafter.
Note: In the case that your employees have income streams in addition to their wages from employment, they will need to know what benefits have been subject to PAYE tax so that they can report it on their self assessment tax return.
Setting up your PAYE payroll
If you’re setting up your business and haven’t yet contracted somebody to manage your payroll, you could set up a payroll system yourself. Or, if you have enlisted assistance, you can delegate these tasks to the person that will be in charge of payroll.
Either way, you will need to have a PAYE system in place before you begin hiring employees.
The first step is to register as an employer with HMRC. This enables you to get your employer PAYE reference number and login details to use with PAYE online. Even if you’re the only director of a limited company or the only employee of a business, you must register.
That said, you don’t need to register for PAYE if none of your employees are paid more than £120 a week, get expenses and company benefits, receive a pension (i.e. they’ve reached their state pension age), or have another job. But your organisation must still keep payroll records.
These records include:
- What you pay your employees (gross pay) and details of the deductions you make (net pay)
- Reports and payments you make to HMRC
- Employee leave and sickness absences
- Tax code notices
- Taxable expenses or benefits
- Payroll Giving Scheme documents (i.e. any donation to charity that your employees make directly from their pay before tax is deducted), including the agency contract and employee authorisation forms
Whether you are registered for PAYE or not, you must keep accurate records for 3 years from the end of the tax year they relate to. Failure to do so could result in a penalty of up to £3,000.
Once you’ve registered as an employer with HMRC, you’ll need to follow the remaining five of the six stages of payroll, which are:
- Register yourself as an employer
- Choose a payroll system
- Keep accurate records
- Tell HMRC about your employees
- Record pay, make deductions and report to HMRC
- Pay HMRC
Top Tip: To learn more about the six stages of payroll, from registering yourself as an employer to accurately paying HMRC, read our complete guide to payroll for small businesses 📌
How is PAYE calculated?
The amount of tax employees must pay is contingent upon their yearly salary. Depending on how much they make, most employees will be eligible for a tax-free personal allowance.
The standard amount your employees can earn without paying tax is £12,570 (this amount applies to the 2021-2022 tax year).
Once they breach that minimum, standard income tax rates and bands apply:
Income Tax rates and bands
|Band||Taxable income||Tax rate|
|Personal Allowance||Up to £12,570||0%|
|Basic rate||£12,571 to £50,270||20%|
|Higher rate||£50,271 to £150,000||40%|
|Additional rate||over £150,000||45%|
Note: The only circumstances in which your employee may not have a P45 is if they are either starting their first job or taking on a second job, or if they are paid less than £120 a week.
PAYE tax codes are composed of numbers and a letter, with the letter sitting at the end of the string of numbers. When multiplied by ten, the number shows how much tax-free income an individual can earn in a tax year.
The most common tax code is 1250L, which makes sense since most people can earn a personal allowance of up to £12,500 per year.
This tax code applies to people with one job and no untaxed income, taxable benefits, or unpaid tax.
The letters reference their employment or tax circumstances and how it impacts their personal allowance (or how much they’re able to make before paying tax).
Remember that you may need to update your employees’ tax codes at the start of the tax year, because the number may change. HMRC will let you know if the tax code changes throughout the year so you can update your payroll records to make sure the correct amount of tax is deducted from each paycheque.
You are also responsible for making National Insurance contributions (NICs) to the government from your employees’ gross pay. These contributions go towards certain state benefits including Maternity Allowance and the State Pension.
As an employer, you must pay ‘secondary’ Class 1 NICs on your employees’ earnings. To see more information about the class 1A, 1B, 2, 3 and 4 employment statuses, head over to the GOV.UK National Insurance classes page.
Similar to the income tax rates, the amount that you must deduct from your employees’ pay depends on how much they earn, as well as their category letter.
Most employees fall into category A. If your employee does not fall into category A, it’s because they are:
- A married woman or widow entitled to pay reduced National Insurance (category B)
- Over the state pension age (category C)
- An employee (of any age) who can defer National Insurance because they’re already paying it in another job (category J)
- An apprentice under 25 (category H)
- An employee under the age of 21 (category M)
- An employee under 21 who can defer National Insurance because they’re already paying it in another job (category Z)
The following table lays out the NIC rates (by category) that you’ll need to pay towards your employees’ National Insurance:
Employer National Insurance rates for the 2021-2022 tax year
|Category letter||£120 to £170 a week (£520 to £737 a month)||£170.01 to £967 a week (737.01 to £4,189 a month)||Over £967 a week (£4,189 a month)|
The rates listed in the above table (e.g. £120 to £170 a week) are called Class 1 National Insurance thresholds.
The thresholds range from “lower earnings limit” (£120 per week, £520 per month, £6,240 per year) to “upper earnings limit” (£967 per week, £4,189 per month, £50,270 per year).
You can only make NICs on earnings on or above the lower limit, which explains why the entirety of the “lower earnings limit” category is 0%.
There’s also no upper limit on an employer’s National Insurance payments.
For example, if you pay an employee £1,000 per week, you would pay:
- Nothing on the first £170
- 13.8% of the wages above £170 (13.8% of £830 is £114.54)
Instead of spending time calculating National Insurance numbers manually, you can use payroll software to calculate National Insurance and tax payments automatically. This will streamline your payroll admin, eliminate the possibility of human error, and save you time and money.
Top Tip: The right payroll software can help you simplify tax filings, ensure you pay the right amount of tax to HMRC, automate calculations and streamline your financial admin. As your business evolves, you may realise new payroll software needs. Learn more about how to upgrade your payroll software in our guide to how to switch payroll providers seamlessly 💡
How to report pay and deductions to HMRC
You’ll need to report your employees’ deductions and payments to HMRC on or before payday.
This includes informing HMRC what you’ve paid employees and everything that’s been deducted. To do this, you’ll need to complete a Full Payment Submissions form (FPS).
Before you complete your FPS, it’s wise to divide staff into groups to make the process easier. For instance, you could do full-time staff, then part-time employees followed by directors.
As mentioned in the previous section, you’ll need your employees’ tax codes and category letters to fill out the FPS accurately.
If you make a mistake in your FPS, make sure to correct it as soon as possible to avoid any potential penalties from HMRC.
You may also need to deduct student loan repayments and make pension contributions for employees enrolled in workplace pension schemes.
In addition to your FPS, you’ll need to send HMRC an Employer Payment Summary (EPS) to claim any reduction on what you owe HMRC (for instance, reclaiming statutory maternity, paternity, adoption, parental bereavement or shared parental payments).
Once you’ve submitted these reports, you’ll then be able to see what you owe HMRC. You can check these figures by signing into your HMRC online account.
Note: If your bill is not what you expected, check that you entered the correct information, such as ensuring that you entered the date you paid your employees on your FPS report and not the date you sent it. If you have double checked everything and still find a mistake, contact HMRC’s employer helpline for assistance.
Usually, you have to pay HMRC what you owe by the 22nd of the month.
However, if you’re a smaller employer that pays employees less than £1,500 a month, you can arrange to pay HMRC on a quarterly basis. If you chose quarterly payments, you must make them by the 22nd of the following month after the end of the quarter. Contact HMRC’s payment inquiry helpline for more details on how to make quarterly payments.
In addition to these reports, you must tell HMRC when a new employee joins or if a current employee’s status changes within the company. For instance, if they become a director or they reach the State Pension age.
You’ll also need to run annual reports at the end of the tax year, informing HMRC of annual employee expenses and benefits.
Top Tip: Even if your business is small, processing payroll can sometimes seem like a complicated process. Between organising payment schedules, making deductions, and arriving at NET pay, it’s a lot to get your head around. Processing payroll efficiently can help ensure that employees are paid accurately and on time each month. Find out how to process payroll and get employees paid on time 🌟
How to pay HMRC
Allow for three working days if you choose to pay by either debit or credit card online, Direct Debit, at your bank or building society, by cash or cheque, or via post using a cheque.
Note: If you are setting up a Direct Debit for the first time, allow 5 working days for the payment to process.
If you want to pay PAYE tax at your bank or building society, or by post, you’ll need to ask HMRC for a payment booklet.
To check that HMRC has received your payment, you can look at your HMRC online account. Payments should show up within six working days.
If you’ve overpaid tax to HMRC, you can apply for a tax refund.
Overpaid tax is most commonly used as credit against future payments. If you prefer, you can apply for a PAYE tax refund at the end of the tax year. Overpaid tax should be reimbursed to the concerned employee via payroll.
PAYE tax deadlines
Staying on top of tax deadlines will help you keep your financial records organised and ensure you avoid any penalties due to late payments.
Here are the key payroll deadlines:
- Before the 22nd of each month, you must pay HMRC deductions from your employees’ earnings in the previous month as reported on your FPS.
- Access your HMRC online account from the 12th of each month to see your FPS and how much tax and National Insurance your business owes.
Top Tip: Managing your business finances while keeping HMRC properly in the loop can be a challenge. We’ve created a handy calendar of key dates for small businesses during the 2021-2022 tax season so you can avoid any HMRC late filing penalties for missed deadlines 📅
Forms for PAYE
Understanding which forms you need for PAYE and when to use them will help keep your financial records in order.
P60 – A P60 is generated for every employee at the end of the tax year and shows how much they’ve paid in tax and National Insurance during the year. You must give your employees P60 forms by the 31st of May each year.
P11D – These forms show how tax has been paid on certain benefits like company cars. You should provide P11D forms to every employee who has received company benefits before 6th July every year.
P45 – These forms are generated when employees stop working for your business and show what they’ve paid in income tax and National Insurance during the tax year. If you don’t supply these to your past employees, HMRC may come after you for them.
Note: Payroll software can quickly generate these forms for you so you don’t miss any important dates.
Common PAYE pitfalls
There are few common PAYE issues that could cause problems with HMRC down the line. Remaining extra vigilant about these common pitfalls will prevent any delays, missed deadlines, or confusion around your business admin.
- Tax codes: It’s easy to include the wrong tax codes on your PAYE forms, which could result in too much or too little income tax being deducted from employees’ pay.
- Incorrect calculations: Businesses may not always correctly calculate or separate expenses, pension payments, and sick pay.
- Late FPS forms: Submitting your FPS forms late may result in a penalty or a written warning if it’s your first time being late. Exceptions may be made if your employee hasn’t given you a P45 form, or if payday falls on a non-banking day.
- Employees leaving: When an employee leaves your business, always remember to take them off the payroll.
- Changes in circumstances: Business owners sometimes forget to calculate changes in pay like pay rises, overtime or bonuses.
Understanding and properly implementing a PAYE system is essential for deducting the correct amount of tax from your employees’ paychecks and ensuring HMRC receives contributions on time.
When you manage PAYE payroll efficiently, you’ll streamline your financial admin and your business will remain HMRC compliant.
Ready to cut expenses, streamline payments and have peace of mind? Tide Payroll is the simple way to pay your team. Just add your employees’ details, choose your pay run date and our software will take care of the rest (coming soon) 🎉
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