Income tax is a more or less universal burden; unless you do not have either paid work or much in the way of savings, you are unlikely to be able to avoid paying it. And failure to pay what you owe can result in financial penalties up to the amount outstanding or, in serious cases, criminal prosecution. So it is worth getting to grips with the basics.
What is taxable
As the name suggests, it is a tax on sources of income, not just earnings from employment or self-employment but also of interest on savings accounts, dividends paid out on investments, rent from properties you let out, most pensions, and even some state payouts such as jobseekers’ allowance.
What is tax free
However, other types of income are not taxed. These include gifts, any money you make by gambling, student loans, grants or scholarships, benefits such as housing benefit and council tax benefit, and earnings from tax-free investments such as ISAs. A full list of exempted income sources is available.
How you pay it
Most people do not have to worry too much about keeping tabs on their income tax. They are paid by their employer through the Pay As You Earn (PAYE) system, which means income tax is deducted from their gross salary before it comes to them; their tax code indicates the amount to be paid.
But higher rate taxpayers, those who are not taxed at source through PAYE, and the self-employed are among those who must complete a tax return and settle up with HM Revenue and Customs (HMRC) each year.
Tax brackets
You can receive a certain amount of income free of tax each year. For 2005/06, people under 65 have a personal allowance of £4,895 before income tax kicks in; those from 65 to 74 have £7,090 and those over 75 have £7,220. The personal allowance rates are reviewed in The Budget each year.
Once your total income from all sources exceeds your personal allowance, there are three tax brackets: in 2005/06 the starting rate of 10% tax covers the first £2,090 of taxable income, the basic rate of 22% applies on the balance up to £32,400 and the higher rate of 40% kicks in on the margin above that. To put that into perspective, if you are of working age and taking into account your personal allowance, you will be paying 22% tax on anything you earn over £6,985, and 40% on earnings over £37,295.
Tax on savings
However, just to complicate matters, tax on savings and investments is treated differently. In both cases it is added on as an additional layer to other sources of income, which means it is taxed at your top rate of income tax. If only part of the savings or investment income falls into the higher tax bracket, only that part will be taxed at the higher rate.
Interest from bank savings accounts is normally taxed at source at 20% rather than 22% up to the basic rate limit (so if, for example, your only income is from a bank account generating £20,000 of interest per year, you will not have anything else to pay).
Savings income that exceeds the higher rate tax band (£32,400) is taxed at 40%, so higher rate taxpayers have to pay the difference. The balance is declared and settled via your tax return, if you usually complete one; otherwise, HMRC will generally collect the extra tax due through adjustments to your PAYE.
Non earners and low earners
What about non earners or very low earners? If your earnings fall within the10% starting tax band then you will be able to claim back part of the 20% tax deducted. If you are a non-earner you can fill in a form R85 from HMRC to receive interest gross of tax.
Dividends
Dividends from UK shares, unit trusts and investment trusts are also treated differently.
The government provides a ‘tax credit’ amounting to 10% of dividend income for shareholders, to take account of the fact that dividends are paid out of already taxed profits (see grossing up). So when your dividend is issued you will receive a statement showing both how much was paid and the tax credit due.
There are two levels of tax on dividends. Basic rate taxpayers are taxed at 10%, which is covered by the tax credit issued, so there is no further tax to pay. Higher rate taxpayers pay 32.5%, minus the 10% tax credit, 22.5%.
Other income sources
Do not overlook other sources of income. If you are a UK resident and have an offshore bank account generating interest, you are obliged to pay UK income tax on it, so make sure you declare your earnings.
UK residents who rent out a property either in the UK or overseas may have to pay UK income tax. But they can offset many of the costs of maintaining and letting out the property against their rental income to reduce the tax bill. (See How to understand tax on overseas properties for more information.)
If your income is complicated, your income tax affairs are likely to be as well, so it may well be worth getting expert advice.
Reducing your income tax
- Additional allowances may be available to increase the amount you can receive tax-free, for example the Blind Person’s Allowance.
- Pensioners also receive a more generous personal allowance (see above), though if they have pension income of more than £19,500 the extra tax-free margin is gradually reduced back down to the standard personal allowance of £4,895.
- The Married Couples' Allowance enables older couples (at least one must be born before 6 April 1935) to reduce their tax bill. (See Save tax as a married couple for more ideas)
- Certain expenditures can also reduce the amount of tax you pay. For example you get tax relief on payments made into a pension scheme, and on donations to charity through Giftaid.
- Under the government’s Rent a Room scheme you can earn tax-free income of up to £4,250 by letting rooms in your own house.
BOOKS
Tax Guide 2005/2006
How to Avoid Tax on your Stock Market Profits
