How is Back Pay Taxed? A Guide for Employees in The UK
Back pay, also called backdated pay, refers to wages that an employer owes to an employee for past work but has not been paid yet. There are several causes leading to the back pay scenario, including payroll errors, salary adjustments, contractual disputes, or deferred pay increments. While claiming and receiving back pay is the right of the employee, it is of utmost importance to understand how it is taxed in the UK so you do not encounter unforeseen deductions from your employer. Therefore, this blog explains how is back pay taxed in the UK, including the tax implications, NICs, and how HMRC handles it so employees can avoid unexpected deductions.
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Take a Look at What is Back Pay:
Back pay is any overdue salary or wages that an employer owes to an employee. It is also referred to as arrears or retrospective pay. Ordinarily, the most common reasons for the occurrence of back pay include:
- Payroll processing errors
- Retrospective pay increases
- Unpaid bonuses or commissions
- National Minimum Wage (NMW) underpayments
- Employment tribunal settlements
- Miscalculated overtime payments
It is worth highlighting that an employer usually includes back pay in an employee’s regular paycheck. As an alternative, they can process it as a separate payment. However, for tax purposes, back pay is treated differently than standard wages.
To learn why back pay is significant, read: What is back pay on a payslip?
How is Back Pay Taxed in The UK?
Before we delve into learning how is back pay taxed in the UK, it is tremendously important to learn how HMRC looks at the back pay. According to the government, arrears of pay are earnings that an employee receives after the date they become entitled to receive them. The employers typically pay these arrears in the form of a lump sum payment. Furthermore, Earnings in arrears are treated the same as if they were paid on time. More importantly, an employee’s legal tax liability for a payment of arrears occurs in the tax year in which the employee was originally entitled to receive the extra amounts, not in the year in which the payments are finally made.
Moving forward, let’s discuss the steps on how is back pay taxed in the UK:
Understand Why Back Pay Has Arisen:
To begin with, the taxation of back pay is not as easy as the tax payment on the received salary. To clarify, generally, employee’s earnings are subject to taxation based on the date they actually receive the payment. Now, there are two key rules to determine it:
- Rule 1 states that taxation occurs on the physical date when the payment is made to the employee, meaning when they receive the money or check.
- Rule 2 implies that if an employee is legally entitled to the payment before they physically receive it, they will be taxed on that date as well.
Ultimately, an employee is taxed on the earlier of these two dates. It is to ensure that income is taxed as soon as it is available to them. However, this entire scenario shows how the taxation of back pay can become quite mind-boggling. To avoid confusion on how is back pay is taxed, it is essential that you grasp why the arrears or back pay has arisen in the first place. Let’s dig a little deeper! If, in the first place, your employer was not legally obligated to grant you a pay rise, any pay you receive will be fully taxable in the year you actually get it instead of it being taxed in any previous tax year.
On the contrary, if the back pay has occurred because your employer has committed a violation of employment law, such as issues related to holiday pay, minimum wage, or equal pay rules, HMRC directives necessitate that taxes should be applied to the arrears based on the year you were entitled to that pay, not the year when you received it. In such situations, you can reach out to your employer to coordinate that tax obligations on that payment are distributed in the year of entitlement to the earnings.
Understand the PAYE System:
First and foremost, employees must know that back pay is subject to the same tax rules as regular salaries. Consequently, it is taxed under the Pay As You Earn (PAYE) system. Nevertheless, considering how HMRC processes it, back pay may impact an employee’s tax bracket and deductions. If you want to learn how a PAYE system works, including how the income tax and NICs deductions are made under it, our following guide will help you a great deal:
Income Tax on Back Pay:
Under HMRC regulations, it is required that back pay be taxed in the period it is received rather than when it was earned. It signifies that if after receiving the back pay, your total taxable income for the current tax year increases, you might fall into a higher tax bracket. Notably, the employer deducts the income tax based on the employee’s tax code and applies the standard tax bands for the ongoing tax year. For instance, for tax year 2024/25, the following are the income tax rates for income exceeding the personal allowance:
- Personal Allowance (0% or tax-free amount): Up to £12,570
- Basic Rate (20%): From £12,571 to £50,270
- Higher Rate (40%) : From £50,271 to £125,140
- Additional Rate (45%): Above £125,140
To get a clearer picture, the following examples illustrate how is back pay taxed in the UK:
For The Basic Rate Taxpayer:
Emma’s annual earnings are £30,000, and she receives £2,000 in back pay. Since her annual income remains within the Basic Rate of income tax, which is 20%, her employer deducts 20% income tax (£400) and 8% NICs (£160) on the back pay.
For Higher Rate Taxpayers:
John earns an annual salary of £48,000 while he also receives £5,000 in back pay. Consequently, his total income now stands at £53,000. Since this total amount surpasses the £50,270 threshold, a portion of his back pay will be taxed at a higher rate of 40%, while the remaining amount will still be taxed at the standard rate of 20%. It indicates that John will have to bear the brunt of an increased tax burden on part of his income since he made additional earnings from his back pay.
Keep visiting the government website for the updated tax rates.
National Insurance Contributions (NICs) on Back Pay:
Similar to income tax obligations, back pay is also subject to NICs, which are deducted during the pay period in which the back pay is issued. It is worth pointing out that NICs are applied based on the earnings in the payment period and not when the wages were actually due.
Moving further, the NICs rates for the tax year 2024/25 are:
Class 1 Employee NICs:
8% on earnings between £12,570 and £50,270
2% on earnings above £50,270
Understanding How HMRC Handles Back Pay?
Importantly, the way HMRC deals with the backdated pay and how it would impact an employee’s allowance and benefits are yet another crucial part of how is back pay taxed. Let’s understand this:
PAYE Tax Codes and Adjustments:
HMRC applies PAYE tax codes for the purpose of ensuring the correct tax deduction from your income. Tax codes are codes that generally appear as a combination of a number and then a letter(s). It should be highlighted that only HMRC sends the code to the relevant payroll department, meaning that the tax codes cannot be changed during your payroll processing since only HMRC can change your tax code. Therefore, it is always vital to check your tax code on each payslip, wherein you may find emergency tax codes. These tax codes may or may not be incorrect. In addition, back pay may also result in a temporary change in tax code (e.g., BR (Basic Rate) or D0 (Higher Rate)).
Further elaborating, if your payslip shows the tax code D0, it means that HMRC will not give you any personal allowance and will tax all your income at 40%. However, if you receive your back pay in the form of a lump sum amount from a former employer with a D0 tax code, and you are a 40% taxpayer, this is the correct code applied, i.e., since D0 takes 40% off, you will pay tax at 40%. Similarly, if your payslip displays the BR code, it signifies that HMRC does not provide you with any personal allowance and taxes everything at 20%. Assuming you are a basic rate taxpayer, this is unlikely to be true, and you might owe tax if you are a higher rate (40%) taxpayer.
Coming back to the discussion, apart from causing a temporary change in the tax code, back pay can also lead to underpayment or overpayment of tax. More importantly, if too much tax is deducted, there is nothing to stress over since HMRC will issue you a refund through your Self-Assessment tax return or an automatic recalculation (P800 tax refund notice).
Impact on benefits and allowances:
Just like the tax codes, back pay may also impact your eligibility for certain benefits or allowances, such as:
- Child Benefit tax charge: If your adjusted net income goes over £50,000, you may have to pay a High-Income Child Benefit Charge (HICBC).
- Student Loan Repayments: If back pay ends up increasing your income (as illustrated through the above-mentioned example), additional student loan deductions may apply.
- Universal credit or tax credits: if you make higher earnings from back pay, it could considerably reduce your benefits eligibility.
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Conclusion:
The crux of the entire discussion is that back pay always ends up being a welcome and pleasant financial boost for an employee. However, it may also accompany unexpected tax implications. Therefore, it is crucial for employees to learn how is back pay taxed in the UK because if it is taxed in the period it is received, it may lead employees to fall into higher tax brackets, which will ultimately affect their take-home pay (net salary), NICs, and eligibility for certain entitlements.
Likewise, grasping the nettle of how HMRC deals with back pay is crucial to avoiding surprises. Hence, if you receive a considerable amount in back pay, it is better to consult with a payroll accountant, who will help you ensure the fulfilment of accurate tax payments and avoid overpayments. More specifically, an employer can avert the occurrence of back pay if no payroll blunder takes place. In this regard, if you are seeking a profound and comprehensive consultation or services regarding your payroll management and tax matters, payrollservices.accountants might just be your right option. With our payroll outsourcing option, you can streamline your payroll process.
Disclaimer: Please note that the information provided in this blog is exclusively for informational purposes and should not be considered financial advice. Always consult with a professional accountant to ensure compliance with UK laws and regulations.
