Properly calculating PAYE (Pay As You Earn) taxation and National Insurance Contributions (NICs) is crucial for ensuring legal compliance and accurate payroll accounting. Both PAYE and NICs are statutory deductions from an employee’s salary, with NICs involving both employee and employer contributions. This guide explains the process of calculating these deductions and recording them in accounting records.
1. What is PAYE Taxation?
PAYE (Pay As You Earn) is a system where employers deduct income tax from an employee’s salary at the source before the net pay is distributed. The deducted tax is then remitted to the tax authority, such as HM Revenue & Customs (HMRC) in the UK.
Components of PAYE Taxation:
- Personal Allowance: The amount of income an employee can earn tax-free. For example, in the UK for 2023/24, the personal allowance is £12,570 annually.
- Basic Rate Tax: 20% applied to income above the personal allowance and up to the higher-rate threshold.
- Higher Rate Tax: 40% applied to income above the basic rate threshold.
- Additional Rate Tax: 45% applied to very high earners (above £150,000 annually).
2. What are National Insurance Contributions (NICs)?
National Insurance Contributions (NICs) are payments made by employees and employers to fund state benefits like pensions, healthcare, and unemployment insurance. The amount contributed depends on the employee’s earnings and applicable thresholds.
Components of NICs:
- Employee NICs: Deducted from the employee’s gross salary.
- Employer NICs: Paid by the employer as an additional expense.
- Primary Threshold: Earnings below this threshold are not subject to NICs.
- Rates: Employees typically pay 12% on earnings above the primary threshold, while employers pay 13.8% on earnings above the secondary threshold.
3. Step-by-Step Guide to Calculating PAYE and NICs
Step 1: Determine Gross Pay
Gross pay includes basic salary, overtime, bonuses, and allowances.
Step 2: Calculate PAYE Taxation
- Step 2.1: Deduct the personal allowance from the gross pay to get the taxable income.
- Step 2.2: Apply the appropriate tax rates to the taxable income.
Step 3: Calculate Employee NICs
- Step 3.1: Identify earnings above the primary threshold.
- Step 3.2: Apply the employee NIC rate (usually 12%) to these earnings.
Step 4: Calculate Employer NICs
- Step 4.1: Identify earnings above the secondary threshold.
- Step 4.2: Apply the employer NIC rate (usually 13.8%) to these earnings.
4. Example of PAYE and NICs Calculation
Scenario: Sarah earns £3,500 per month. The personal allowance is £1,047.50 per month (£12,570 annually). NIC thresholds are £1,048 for employees and £758 for employers.
A. Calculate PAYE Tax:
- Gross Monthly Pay: £3,500
- Personal Allowance: £1,047.50
- Taxable Income: £3,500 – £1,047.50 = £2,452.50
- PAYE Tax (20% on taxable income): £2,452.50 × 20% = £490.50
B. Calculate Employee NICs:
- Primary Threshold: £1,048
- NICable Income: £3,500 – £1,048 = £2,452
- Employee NICs (12%): £2,452 × 12% = £294.24
C. Calculate Employer NICs:
- Secondary Threshold: £758
- NICable Income: £3,500 – £758 = £2,742
- Employer NICs (13.8%): £2,742 × 13.8% = £378.40
D. Summary of Deductions:
- Gross Pay: £3,500
- PAYE Tax: £490.50
- Employee NICs: £294.24
- Total Deductions: £784.74
- Net Pay: £3,500 – £784.74 = £2,715.26
- Employer NICs: £378.40 (additional cost to the employer)
5. Journal Entries for PAYE and NICs
A. Recording Payroll and Deductions
| Date | Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|---|
| Jan 31 | Wages and Salaries Expense A/c | £3,500 | |
| PAYE Tax Payable A/c | £490.50 | ||
| Employee NIC Payable A/c | £294.24 | ||
| Cash/Bank A/c (Net Pay) | £2,715.26 |
B. Recording Employer’s NICs
| Date | Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|---|
| Jan 31 | Employer NIC Expense A/c | £378.40 | |
| Employer NIC Payable A/c | £378.40 |
C. Payment to Tax Authorities
| Date | Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|---|
| Feb 15 | PAYE Tax Payable A/c | £490.50 | |
| Employee NIC Payable A/c | £294.24 | ||
| Employer NIC Payable A/c | £378.40 | ||
| Cash/Bank A/c | £1,163.14 |
6. Importance of Accurate PAYE and NIC Calculations
- Legal Compliance: Ensures adherence to tax laws and regulations, avoiding penalties and fines.
- Accurate Financial Reporting: Proper recording of PAYE and NICs ensures financial statements reflect true payroll costs.
- Employee Trust: Accurate deductions foster trust and transparency in payroll processes.
- Budgeting and Forecasting: Helps businesses manage cash flow and plan for labor costs effectively.
Managing PAYE Taxation and NICs
PAYE Taxation and National Insurance Contributions are critical elements of payroll accounting. Accurate calculation and timely remittance of these deductions are essential for legal compliance, financial accuracy, and maintaining employee trust. By following systematic procedures for calculating, recording, and remitting PAYE and NICs, businesses can ensure smooth payroll management and reliable financial reporting.