1. National Insurance for Normal Employees
All employees pay no national insurance on earnings below a minimum threshold (the primary threshold), a higher rate for all their earnings between a lower and an upper threshold (the upper earnings limit), and a reduced rate for earnings above the upper threshold.
For employees who are not directors the national insurance thresholds are divided up evenly over the pay periods (months, weeks or 4 weekly intervals) throughout the year. If an employee received pay in excess of the upper threshold in one pay period, then below the lower threshold in the next pay period, the employee pays less national insurance.
2. Special Rules for Directors
To prevent tax avoidance which would occur if all director's pay in a tax year was put into a single pay period, HMRC apply special rules to directors. In this case, the thresholds are applied for an entire tax year and not for a particular pay period.
2.1 The Annual Cumulative Method
In the annual cumulative method, the NI lower thresholds for directors for the entire year becomes immediately available in the first tax month.
After this threshold is exceeded, all director's pay becomes subject to NI until the upper threshold is reached.
This has the effect of increasing director's net pay in the first few months of the tax year, and decreasing it thereafter.
This method is the one implemented in Clear Books currently. The relevant legislation is set out in Section 2(1) of the Social Security Contributions and Benefits Act 1992.
2.2 The Year to Date Cumulative Method
In the year to date cumulative method, the entire NI threshold is not released immediately. Instead, an estimate is made of the director's pay for the entire tax year based on pay to date. A proportion of the NI threshold for the entire year is released in each pay period, depending on:-
- how far along in the year the pay period is
- how much NI threshold has been released to date
This has the effect of smoothing director's net pay throughout the tax year.
Over the course of a tax year, the total NI paid under either method will be the same. In the annual cumulative method, less NI is paid earlier in the tax year and more is paid later. Regulation 8(6) of the Social Security (Contributions) Regulations 2001 permits but does not require the use of the "year to date cumulative method."