These innocuous-looking documents (summaries also go to employers) determine how much disappears from pay packets into the pockets of the Inland Revenue. Codings are essentially a guess based on the information the Revenue has from the year before and some sources have put the number of incorrect codings as high as 80 per cent.
This can lead to underpaying, or overpaying, tax during the year. So what is this notice that you've just received and no doubt instinctively put at the back of a drawer?
One side of the coding notice will be marked "tax allowances" and calculates your total tax-free allowances. The two most frequent allowances shown will be the personal allowance (to which everyone is entitled) and the married couple's allowance.
Under self-assessment, to be introduced in April, the Revenue is trying to make tax codings more comprehensive, so this section may also include personal pension relief or loan interest for those people who do not receive tax relief under Miras. Some employment expenses not reimbursed by your employer may also be shown here as an allowance. Any other allowances shown here are likely to be self-explanatory and you will be aware if they are applicable to you.
The other side of the form will be headed "Amounts Taken Away". Most importantly, this section covers the benefits you receive from your employer. Car and fuel benefit calculations are shown in the Inland Revenue guide which accompanies the tax coding.
The two sections are set against each other, which will produce a positive or a negative figure. If, for example, in 1997/98 a single person has benefits in kind of pounds 1,000 this will be deducted from the personal allowance of pounds 4,045 leaving allowances of pounds 3,045.
The figures in the code will therefore be 304 (as in the first three numbers in pounds 3,045), which will then be followed by a letter (either L, H, P or V). Usually the letter is L, which means the single allowance only; H links to the married allowance, P to pensions. Things start to get confusing with restrictions which hit the amounts taken away. The Revenue will restrict some of the allowances, such as married couple's allowance, as relief is only given at 15 per cent. The restriction in your coding recovers excessive relief and is the difference between your top rate of tax and 15 per cent.
The state pension is also included in this section. In addition, the Revenue is incorporating items of untaxed income, such as property income and untaxed interest, into this section.
Putting all this together, and throwing in benefits from the employer, it can mean that the amounts taken away are bigger than the allowances. Going back to the earlier example, if benefits and restrictions amounted to pounds 6,000, that exceeds the personal allowance by pounds 1,955.
This is dealt with by the K code system: the taxpayer would get a code of K194, from the first three figures of the negative amount reduced by 1.
As noted earlier, many tax codes are wrong. The most frequent instances of a tax coding being incorrect come when there has been a change in your personal or financial circumstances - you've got married, you receive a company car (or give it up), you buy a new property and rent it out.
These are the times when it is most important to check your coding notice, as the amount of tax deducted will be going wrong. This could be good or bad news; either way you should know about it.
It is tempting to ignore an underpayment, but do bear in mind that the Revenue will catch up in due course. As for an overpayment - as most people don't complete a tax return at the end of the year, you might never get it back unless you look at your code.
If you believe your notice of coding is wrong you should contact the issuing office. The phone number is on the notice. A revised notice of coding will be sent to you and your employer.
It is a surprisingly simple procedure and one that could save difficulties when the end of the year arrives and you realise that you forgot to include the Inland Revenue in the list of people to tell about your marriage.
John Whiting is a tax partner at Price Waterhouse.Reuse content