In Payroll, what is the difference between Income Tax and National Insurance?
An employee’s payslip will usually show two deductions on the right-hand side: one called tax and one called National Insurance, employee NI, NIC, or simply NI. The tax is Income Tax, often called PAYE tax because it is deducted through payroll. PAYE stands for Pay As You Earn — a rare example of payroll terminology doing what it says on the tin.
Put simply, both Income Tax and National Insurance are taxes, but they work in different ways. Income Tax is a tax on income; National Insurance is a social security contribution. They have different rates, thresholds and rules, so they need to be calculated separately.
We are not going to dive into every possible definition of earnings here. That can get very technical, very quickly, and for most employers it is not relevant because their pay arrangements are straightforward.
| Area | Income Tax | National Insurance |
|---|---|---|
| What it is | A tax on income, deducted through PAYE for employees. | A social security contribution, also deducted through payroll for employees. |
| What figure it uses | Taxable pay. | Pay subject to NI. |
| Benefits in kind | Usually increase taxable pay, even if no extra cash is paid. | Usually do not affect employee NI, though employer NI may still apply. |
| Salary sacrifice | Usually reduces taxable pay, but some arrangements can create a benefit in kind. | Usually reduces pay subject to NI. |
| Pensions | Treatment depends on the pension scheme. Net pay arrangements reduce taxable pay; relief at source arrangements do not. | Usually no effect on NI for either net pay or relief at source pension arrangements. |
| How it is calculated | Usually based on the tax code, tax bands and whether the code is cumulative or period-only. | Usually calculated each pay period using NI category, thresholds and rates. |
| Why it matters | Affects the employee's net pay and depends heavily on tax code and taxable earnings. | Affects net pay, statutory payment calculations and state pension records. Not just decorative payslip confetti. |
Income Tax
Income Tax is a tax based on income. Simple so far — payroll does occasionally let us have one. Not all payments are subject to Income Tax; some business expenses, for example, may be allowable and therefore not taxable. On a payslip, this is one reason why gross pay and taxable pay may be different.
Benefits in Kind
Benefits in kind are usually subject to tax. They can increase taxable pay even when they do not increase the amount of cash the employee actually receives. In the tax calculation, all taxable pay types are added together to produce the taxable pay figure.
Salary Sacrifice
Salary sacrifice, also known as salary exchange, normally reduces taxable pay. However, not every salary sacrifice arrangement is fully allowable for tax purposes, and some can create a benefit in kind that increases taxable pay again. Pensions and cycle-to-work schemes are common examples of allowable arrangements; company cars are more likely to bring a benefit in kind along for the ride.
Pensions
Pensions often appear to complicate matters because the tax treatment depends on the scheme. A relief at source pension is deducted from net pay and does not reduce taxable pay. A net pay arrangement is deducted before tax, so it reduces the taxable pay used in the calculation. You may also hear this described as “gross for tax”.
The calculation
Tax calculations are usually manageable once you know whether the tax code is cumulative or being applied on a period-by-period basis. If it is being used for the current period only, there will usually be a month 1/week 1 flag, a “Y”, or similar. For example: S1257L Wk1 or C1257L Y.
Once you know whether the calculation is cumulative, you can normally use the calculation method, although tax tables still exist. In day-to-day payroll, HMRC-approved software will usually do the heavy lifting in the background. That said, it is still useful to understand what has happened on a payslip.
You use the appropriate thresholds for the employee. Usually, part of the pay is tax-free, then further amounts are taxed at 20%, 40% and so on. Scottish payslips have additional rates and thresholds, but the principle is the same. England, Wales and Northern Ireland are a little more straightforward.
Tax codes: These can make a dramatic difference to the calculation. Most employees will have an L or T code and nothing too alarming will happen. Some special codes, such as K, BR, D0 and D1, work differently, but we will leave those particular rabbits in their holes for now.
National Insurance
National Insurance, or NI, is usually calculated each pay period. The main exception is directors, where a cumulative NI method may be used. We will not cover directors here, as that is a separate payroll adventure.
There are several NI categories — 24, in fact — each with a slightly different effect. Most UK employees are category A. NI is also split between employee NI and employer NI. Employee NI is deducted from the employee’s pay; employer NI is an additional cost for the employer. We will focus on employee NI here.
There are also different classes of NI, but this article is only looking at employees’ Class 1 NI. As with tax, gross pay may be different from pay subject to NI. The first step is to work out which earnings are subject to NI.
Benefits in Kind
Generally, benefits in kind have no effect on employee NI. Employer NI may still apply, but that is usually dealt with outside the payroll calculation. Where benefits are processed via payroll, it is common to see taxable pay higher than pay subject to NI.
Salary Sacrifice
Salary sacrifice arrangements reduce pay subject to NI. Even if a benefit in kind charge arises for tax purposes, it will not usually affect employee NI.
Pensions
Neither relief at source nor net pay pension arrangements affect NI. Where there is a net pay arrangement, it is common to see pay subject to NI higher than taxable pay.
The calculation
The NI calculation is less friendly than the tax calculation. Tables can be used, but you may simply want to calculate a payslip as a check or to understand what has happened. For an employee, there is usually a portion of pay below the threshold, then some charged at 8%, and potentially some charged at 2%.
To calculate NI, you need the pay subject to NI and the employee’s NI category. Once you have those, you can apply the rates and thresholds for the relevant pay period, split the pay across the thresholds, and calculate the employee NI due.
They sound similar does it matter?
If you are an employee, you are probably most interested in the bottom line: what lands in the bank. The fact that deductions are split between Income Tax and NI may not feel important day to day. However, the NI thresholds are high for employees, which is good, and much lower for employers, which is less cheerful. That had a significant impact on employer NI last year.
National Insurance is still worth understanding. Pay subject to NI is used when working out eligibility and rates for statutory payments such as SSP, SMP and ShPP. It is also used for state pension calculations, so it is not just another mysterious line on the payslip.
For employers, pay subject to NI is also used for the Apprenticeship Levy, and employer’s NI liability can be reduced by parental leave rebates and Employment Allowance.
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