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
You don’t pay tax on things like:
- Earnings below the personal allowance
- Your first £1,000 of self-employment income (trading allowance)
- Your first £2,000 of dividend income (dividend allowance)
- Your first £1,000 of interest on savings
- Premium bonds or lottery winnings
- Income from a lodger under £7,500 (rent-a-room scheme)
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%||£12,500||£12,500|
|Basic rate 20%||£12,501 to £50,000||£12,501 to £50,000|
|Higher rate 40%||£50,001 and £150,000||£50,001 and £150,000|
|Additional rate 45%||over £150,000||over £150,000|
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
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 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
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
New Here? Learn how to set up the financial side of your business with these easy to understand guides and resources:
- Sole Trader or Limited Company? – Download my free calculator to check which business structure would help you to pay less tax;
- Government Support For the Self-Employed During Coronavirus – Find out about the schemes available, which ones you are eligible for and how to claim;
- Tax Records and Bookkeeping – Understand what tax records you’ll need to keep and how to set up your own bookkeeping system;
- How to Fill In Your Tax Return Online – In this step-by-step guide, you’ll find everything you need to know to fill in your tax return online and beat the HMRC deadline.
- Self Employment Taxes Explained – Learn what taxes you’ll pay, how much and when;
- VAT Guides – From registration to de-registration, VAT schemes and thresholds, these guides will take you through the basics every UK small business owner needs to know;
- Invoice Template – Free template and step-by-step guide so you can get paid by your clients.