We outline the rules that determine how much income tax you pay, and flag up some tax-saving tips.
Income tax rules
The income tax you must pay varies according to your income in a given tax year, which runs from 6 April to 5 April. Everyone receives a personal allowance – £12,500 for the 2019/20 tax year. You pay no tax on income up to this threshold.
If your income exceeds the personal allowance, income tax must be paid on the excess. The rate you pay rises in bands, starting with a basic rate of 20%, then a higher rate of 40% and ultimately an additional rate of 45%, depending on your earnings (see below). Your allowance falls by £1 for every £2 of income you earn above £100,000 a year, dropping to zero once your income reaches £125,000.
Income tax rates
|Tax band||Income (£)||Tax rate (%)|
|Basic rate||12,500 to 50,000||20|
|Higher rate||50,000 to 150,000||40|
Savings and investments
Savings income such as interest earned on bank or building society accounts and bonds is added to your income from employment to calculate your income tax. Confusingly, however, savings income is subject to its own system of thresholds and tax-free allowances. Your allowance for tax-free savings income is made up of three elements:
1) The ordinary personal allowance: Use this to shield savings tax-free if you have not used the allowance up through salary, pension or other income.
2) The starting allowance for savings: This lets you receive £5,000 of savings income tax-free. But the allowance is lost if your other income is £17,500 or more. If your other income is less than £17,500, your starting allowance for tax on savings is reduced by £1 for every £1 of other income you earn above your personal allowance.
3) The personal savings allowance: This new allowance, introduced in 2016, depends on your income tax band. It’s £1,000 for basic-rate taxpayers, £500 for higher-rate taxpayers and zero for those who pay the additional rate.
Savings income does not include interest earned on Isas and NS&I holdings such as premium bonds, or dividend income from Isas.
You only pay tax on dividends if their value exceeds your annual dividend allowance, which in the 2019/20 tax year is £2,000. The tax rate you pay on excess dividends depends on your income tax band. Your dividend income is added to your other income in order to calculate your income tax band.
Dividend tax rates
|Tax band||Tax rate on dividends over your allowance (%)|
If you receive £3,000 in dividends in this tax year, for example, your dividend allowance of £2,000 means you only pay tax on £1,000 of your dividends.
Let’s say your other taxable income amounts to, say, £35,000. You must add the full £3,000 in dividends to this to determine your taxable income, in this case £38,000. You pay a rate of 7.5% on £1,000 of dividends because your total income remains within the basic-rate tax band.
Sole traders, partnerships and companies
Any profits or cash a sole trader takes from their business will be subject to income tax at their highest marginal rate, and national insurance contributions (NICs) will also be payable.
It’s a slightly different situation for partnerships. Partnerships can pay you a salary as well as a share of business profits each year. You must pay NICs on both the salary and the partnership profits you receive. However, no employer’s NIC is payable on partnership profits (whereas there is on a salary), and the NIC rate is slightly lower for partnership profits.
If you run an incorporated company, you can choose to pay yourself a salary, which will be taxed as employment income. However, if you own shares in your business, you can pay yourself dividends. This has traditionally been considered a cheaper option, because dividends are taxed at a lower rate than salary, and NICs are not payable on dividend income.
The catch is that dividends are not deductible for corporation tax purposes, so this will cost your business more money. However, the overall difference in tax between taking a salary and taking a dividend is small.
You can only pay dividends if you have sufficient capital reserves in your company – which rules out loss-making companies paying out in their early years of trading – and the board of directors votes to do so.
Some of the costs incurred in running your business can be deducted from your business’s income when calculating your profit. These include the costs of running an office (stationery and office rental, for example), and paying staff and sub-contractors. Financial costs such as bank charges and insurance can also be deducted from your profit, as can marketing and travel expenses as well as the cost of buying raw materials
You can do quite a lot to reduce your tax bill by making full use of these ‘allowable expenses’. For example, you can charge for clothing that you use in the course of your work, such as a uniform. Comedian Andy Parsons claims his cotton underpants are tax-deductible, as hot stage lights would otherwise cause chaffing.
If you are self-employed, you are required to complete a self-assessment tax return after the end of the tax year. Paper-based returns must be filed by 31 October; online returns must be submitted by 31 January. If you miss the appropriate filing deadline, a £100 penalty is charged. If after three months you have still not filed, a larger penalty will be imposed.
HMRC will calculate what you owe, and you must pay this amount by 31 January. If payment is 30 days late, a penalty of 5% of tax owed is applied. Larger penalties are due after 6 and 12 months if you continue to withhold payment. Records of all your business transactions, such as receipts and bank statements, should be kept for five years.
Tax codes normally start with a number and end with a letter. The number reveals how much tax-free income you are currently entitled to (though the last digit of the figure is removed). The letter is a code that you can look up on HMRC’s website.
For example, ‘L’ after the number means you are entitled to the standard personal allowance, so 1250L is the tax code used for most people who have one job or pension. An ‘M’ means you have received a transfer of 10% of your partner’s personal allowance. An ‘N’ means you have transferred your personal allowance to your partner. Emergency tax codes end in ‘W1’ or ‘M1’.
‘K’ codes are negative codes that mean you have income (or had income the previous year) that is not being taxed any other way, and HMRC is now collecting the tax on it.
Your employer or pension provider takes the tax due from your wages or pension – even if another organisation is paying the untaxed income to you – but it cannot deduct more than half of your pre-tax salary or pension.
Top tax rescue techniques
• If your income is more than £100,000 a year, your £12,500 personal allowance will be scaled back until, at £125,000, it has gone. One way to claw it back is to make a pension contribution. If you earn £125,000 and you pay £20,000 into a personal pension, HMRC will add tax relief of £5,000 to your contribution.
What's more, you can use your tax return to claim back a further 20% in tax relief (the higher-rate tax relief on your pension contribution), resulting in a tax rebate of £4000.
The £20,000 pension contribution also means you will regain £10,000 of personal allowance, reversing the loss of £1 of allowance for every £2 of income you earn above £100,000 – a further tax saving of £4,000 (£10,000 x 40%).
In addition, income of between £100,000 and £125,000 is effectively taxed at a rate of 60%, because not only are you taxed at 40% on every additional £1, but the higher-rate threshold at which tax is charged also falls in step with the personal allowance, so this will give you back an extra 20% per £1, or £2,000. That’s a tax saving of £10,000, plus £25,000 into your pension.
• In many couples, one partner earns less than the personal allowance and pays no tax, but they can still make a pension contribution and receive tax relief. HMRC will pay the equivalent of 20% of your contribution into a pension up to your gross earnings (or £3,600 if you have no earnings), even though you have paid no income tax.
• Most people know they can shelter £20,000 a year in an Isa. But many may forget that venture capital trusts offer tax relief of up to 30%. Moreover, any dividends are tax-free and growth is exempt from capital gains tax.