Income Tax Explained

Income tax is a type of tax you pay on your earnings. In this guide, you’ll find out what it is, how you pay it and how’s it calculated as well as the reliefs available to reduce what you pay.

What is Income Tax?

Income Tax is a tax you pay on certain types of income, such as:

  • Employment income
  • Self-employment profits
  • Rental income
  • Some state benefits
  • Employment benefits
  • Interest on savings
  • Dividends

You don’t pay tax on things like:

You’ll pay tax no matter how old you are. It is connected to income not age, but there are different reliefs available which can depend on age and income type.

How You Pay Income Tax

You’ll pay income tax in two ways:

PAYE “Pay as You Earn”

If you are employed, your employer will deduct your tax every time they pay you. You’ll be paid after tax and your employer is responsible for paying your tax to HMRC.

Self-Assessment Tax Return

If you are self-employed or have received other types of untaxed income, then you’ll need to submit a self-assessment tax return form declaring your income and then pay your tax.

How Much Income Tax Do You Pay?

For the 2020/2021 tax year* you can earn up £12,500 tax-free. After this, you’ll pay income tax at 20% on your earnings up to £50,000 and 40% over that amount, until you reach £150,000 and have to pay 45%.

*the tax year runs from 6 April to 5 April each year

Personal allowance 0%£12,570£12,570
Basic rate 20%£12,570 to £50,270£12,570 to £50,270
Higher rate 40%£50,271 to £150,000£50,271 to £150,000
Additional rate 45%over £150,000over £150,000

Example 1

You are self-employed and during the tax year 2020/2021 you make a profit of £40,000.

You’ll need to pay tax of £5,500 which is calculated as:

  • 0% on the first £12,500 profit
  • 20% on the remaining £27,500 profit

Example 2

You are employed and self-employed, so have two forms of income. During tax year 2020/2021 you earned:

  • £40,000 from your employment
  • £12,000 profit through self-employment

That means your combined income from both is £52,000.

Your income tax bill for 2020/2021 would be £8,300 which is calculated as:

  • 0% on the first £12,500 income;
  • 20% on the next £37,500 income;
  • 40% on the last £2,000 income.

In addition to income tax, you’ll need to pay two types of National Insurance – Class 2 and Class 4. Again, the more you earn the more you’ll pay.

Personal Allowance Restriction

The personal allowance is reduced for anyone that earns over £100,000 (this is known as the personal allowance restriction).

It is restricted by £1 for every £2 of your income over £100,000. That means once earnings reach £123,000 in you will lose all your personal allowance.

Income Tax Reliefs and Allowances

Income tax allowances and reliefs reduce the amount of tax you have to pay. The ones you can claim depend on your personal circumstances, employment status and business spending. Examples include:

  • Personal allowance
  • Pension allowance
  • Capital allowances
  • Marriage allowance

I’ve put together a detailed guide containing the most popular Income Tax Reliefs and Allowances so you can find out which ones you might be entitled to and how you can claim them.

National Insurance

National insurance is another type of tax paid by earners who are over 16 in the UK. It’s another type of tax where UK workers (whether employed or self-employed) pay into a ‘pot’ which then entitles them to claim certain state benefits such as:

  • Unemployment benefits
  • Statutory sick pay
  • Maternity pay
  • State pension
  • NHS

In most cases you’ll start paying national insurance once:

  • your employment earnings are above £166 a week
  • your self-employment profits are more than £6,365 a year

More about National Insurance

About Anita Forrest

Anita Forrest is a Chartered Accountant, spreadsheet geek and money nerd helping financial DIY-ers organise their money so they can hit their goals quicker.