How Income Tax and National Insurance for employees are calculated in FreeAgent

This article explains how Income Tax and National Insurance (NI) are calculated on payslips in FreeAgent for employees (including directors), under the PAYE system, and how to check the calculations.

Please see below for answers to the most common questions about staff Income Tax and NI calculations on payslips that we get from our customers who are using FreeAgent’s payroll feature.

• How does FreeAgent calculate Income Tax and NI deductions?
• How can I check the calculations?
• Why is there a refund shown and do I need to pay this?
• Why is tax being deducted from my employee before they have reached their annual allowance?
• Why is Employee and/or Employer NI being deducted in some months but not others?
• Why is a Director's NI calculated when they are below the annual threshold?
• Employment Allowance has been claimed so why is Employer NI calculated and due to be paid to HMRC?
• What does it mean when there is an ‘X’ suffix on the tax code?
• How does my business pay PAYE/NI or claim a refund if I have overpaid? 

How does FreeAgent calculate Income Tax and NI deductions?

FreeAgent will calculate the Income Tax and NI due on each payslip based on the employee’s pay, deductions, tax code, NI basis selected and category letter entered in their payroll profile.

The calculations are based on the National Insurance rates and thresholds we get from HMRC each tax year. 

At the start of the tax year

FreeAgent automatically updates the calculations each year based on the data sent to us by HMRC in advance of the new year beginning. You’ll be asked to review the tax codes in the payroll profiles when starting a new payroll year.

From 1st April each year, you’ll be able to set up payroll ready for the new tax year and if you've been paying employees the maximum pay that keeps them under the thresholds, FreeAgent will suggest a new monthly gross pay amount on the new payroll profile for the year when starting a new payroll year.

On-going through the tax year

Please note that if you edit any payslips from a previous month in the tax year or update the employee’s payroll profile, this will immediately update the tax and NI calculations in the employee’s Year to Date figures. However, HMRC won’t receive the updated information until the next RTI submission is made. This means that the adjustments will not show on the next payslip created but the correct Year to Date figures will be sent to HMRC in the next submission.

Other figures to consider when checking tax and NI calculations are the cumulative pay to date and tax/NI paid to date. If you’ve been running your payroll in FreeAgent for the entire tax year so far and the employee has been with you since before the start of the tax year, these can be found on previous payslips for the tax year in FreeAgent. 

Alternatively, if you moved your payroll to FreeAgent during the tax year, or the employee joined during the tax year, then you’ll need to make sure you enter the cumulative figures for pay and tax/NI to date into the employee’s payroll profile. If you’re moving all of your payroll from another system, you’ll find this information in your previous payroll records. If the employee is a new starter, the pay and tax to date will be in the P45 they give you when they join, for the current tax year. For new joiners you do not need to enter NI to date since NI is calculated separately for each job the employee has.

It’s the total pay to date that will nearly always be used in the tax/NI calculations, not just the pay run through the FreeAgent account. Therefore, if you take on a new employee during the tax year, their tax/NI figures may look higher than expected.

How can I check the calculations?

If the amounts shown on a specific payslip are not as you would expect, here are some things to check:

• Has the correct pay field been used on the payslip? (Is it subject to tax/NI, statutory pay, deductions, pension contribution fields?)
• Are the tax & NI settings on the payslip correct? (Have these been updated since the payslip was prepared from the payroll profile or need to be updated?)
• Has the correct NI contribution basis been selected and if the user is a director whose directorship began in the current tax year, is there a correct ‘Director start date’ entered after 6th April in the payroll profile? This is important because when a director starts part-way through the tax year, the threshold at which NI kicks in for them will be lower, according to HMRC guidance.
• Are the Year to Date figures on the payslip correct? (Do these reflect any changes made to previous payslips during the year or to figures brought in from another payroll system?)

If all the above points look as expected but you’re still not sure that the tax/NI are correct, please check the figures against HMRC calculators and remember to choose the correct tax code, NI basis and enter a start date for a director (if the directorship began after 6th April).

Why is there a refund shown and do I need to pay this?

Occasionally, employees may have overpaid tax or NI earlier in the year. You would be seen as an intermediary for HMRC and so would pay them the refunded amount due on HMRC's behalf.

HMRC would then offset this refund that you pay to the employees against any future amount owed by you on their behalf for tax or NI. If you won't be collecting enough deductions in the future to have a balance due to HMRC, they may issue you a refund directly.

Why is tax being deducted from my employee before they have reached their annual allowance?

As FreeAgent supports monthly payroll only, the personal allowance for the year is divided into 12 monthly amounts to represent the allowance for each month. This means for an employee with tax code 1257L, their annual allowance is £12,570, which is £1,048 each month (£12,570 /12 rounded up).

If their taxable pay in a month goes above £1,048, some employees will start seeing tax due for that month if the cumulative total pay to date for the year is over the allowance used up at that point, even if the year-to-date pay for the year has not reached £12,570 yet. 

Why is Employee and/or Employer NI being deducted in some months but not others?

If the employed individual is not a director, they pay NI monthly. This means that each time the employee is paid, the employee NI contributions are calculated based on their monthly pay.

However, if the employed individual is a director, they have the option to pay their NI cumulatively, so that they pay less at the start of the tax year and more at the end. This means that employee NI will start to be deducted from their salary when their cumulative NICable salary for the tax year to date goes over the primary threshold. This is calculated on an annual basis and you would expect to see less or no NI contributions calculated in the earlier months and higher contributions in the later months of the tax year.

Alternatively, directors can choose to pay their NI monthly like an employee. This means that each time the director is paid, the employee NI contributions are calculated based on their monthly pay. This is the Director (alternative arrangements) basis.

You can check the NI contribution basis used on an individual’s payroll profile or on the payslip itself. 

Why is a director’s NI calculated when their salary to date is below the annual threshold?

If the individual became a director of the company during the current tax year, there should be a ‘Directorship Starting Date’ entered on the payroll profile. 

When a director starts part-way through the tax year, the threshold for how much salary they can receive before they start paying NI contributions is calculated pro rata so they would start having NI calculated before they reach the full annual threshold. 

Employment Allowance has been claimed so why is Employer NI calculated and due to be paid to HMRC?

The Employment Allowance is not a cash-back scheme and doesn't stop employer’s NI contributions from being calculated, it reduces the amount you pay. If you are eligible as an employer to claim this allowance and you have shown this in the payroll settings in FreeAgent, the allowance reduces (or eliminates) your employer’s NI payment to HMRC every month until you reach the total allowance for that tax year.

The amount of employer's NI calculated will show on the summary page for each employee and on the Payroll summary screen each month. 

The amount of Employment Allowance claimed for the month shows separately, and this reduces the amount due to HMRC.

What does it mean when there is an ‘X’ suffix on the tax code?

The 'X' at the end of a tax code means that HMRC are looking for the tax to be calculated on what is called a ‘Week 1/Month 1’ basis.

You can add an emergency tax code to an employee's payroll profile in FreeAgent by entering the tax code as *****L. You should then see an option just below the tax code fields which asks if you want to ‘Make deductions on a Week 1/Month 1 basis?’.

If you select 'Yes' for this option and save the changes, that will mean the tax is calculated on a non-cumulative basis (on what they are paid in the current pay period, not the whole year).

How does my business pay Income Tax and NI under PAYE or claim a refund if I have overpaid? 

Find out how to pay your PAYE, reclaim a NI refund and apply for financial help for an employee tax fund from HMRC.

You can see the amount your business owes HMRC on the Tax Timeline in FreeAgent. 

If the amount you see there does not match what HMRC says your business owes, this may be due to timing, changes made to the opening balances or edits to previous payslips that have not yet been updated with HMRC.

To explain bank transactions within FreeAgent for PAYE/NI, read how to explain a PAYE payment and PAYE refund.