Income Tax Introduction

To kick off this tax guide, it's worth putting the various forms of tax in context, so you see exactly how much each type contributes to the government's coffers each year.

The table below illustrates the expected tax haul for the 2004-05 tax year (a tax year in the UK runs from April 6 to April 5).

Type of tax	£bn	% of total
Income tax (net of £5b in tax credits)	122.3	28.7
National insurance	78.1	18.3
VAT	73.0	17.1
Corporation tax	33.9	8.0
Fuel duty	23.3	5.5
Council tax	20.2	4.7
Business rates	18.7	4.4
Stamp duty	8.9	2.1
Tobacco	8.1	1.9
Alcohol	7.9	1.8
Road tax	4.9	1.1
Inheritance tax	2.9	0.7
Capital gains tax	2.3	0.5
Other	21.9	5.2
Total	426.4

All this tax is sucked out of us in many different ways. Income tax and national insurance are typically deducted from your salary under the PAYE system. Other taxes such as VAT, fuel duty, tobacco, alcohol etc are slapped on prices and you pay them when you buy goods and services. Council tax and business rates are collected by local councils and so on.

In this series, we're going to concentrate on the taxation of individuals and more specifically on income tax, national insurance, capital gains tax, inheritance tax and stamp duty. Note that this is only intended to be an introductory guide. Tax rules are complex and change frequently. If you're in any doubt at all, and especially if serious sums are involved, you will probably need specialist tax advice.

We're going to kick off with income tax.

Income tax

Income tax is charged on various sources of, er, income. The most common are salaries, pensions, income from self employment and investment income.

Pension income includes the state retirement pension, pensions from former employers and also from personal pension schemes. Investment income is primarily interest and share dividends and this will be dealt with elsewhere. There are also other forms of income, such as that received from letting property or a voluntary purchased annuity, for example.

Most income (but there are many exceptions) is subject to income tax by deduction at source. If you are employed then tax will be deducted under the PAYE scheme. If you have interest received, tax is usually deducted by the payer. Note that the PAYE scheme is not in itself a set of tax rules to calculate liability - it is merely a convenient collection method for the Government, which compels employers to operate the scheme and pay over the tax so collected each month.

Common exceptions to deduction at source include self-employed income and, following a recent change in the rules to make them more attractive to individuals, interest on gilts.

Despite the presence of income tax deduction at source, this is not necessarily the end of the matter. It is only when all your income for a tax year is added together that the total tax liability can be calculated. Credit is then given for tax already deducted and you may owe more, or possibly less, entitling you to a refund. The mechanism by which this is ascertained is the Annual Tax Return - a fun form to fill in if ever there was one!

A large number of people do not have to file returns, unlike in some other countries like the US where everybody has to file. In the UK, though, HM Revenue & Customs do not usually require returns from those whose tax deductions at source effectively amount to their total liability for the tax year. This will apply for example to the majority of employed people whose income from that employment, together with any other income such as from investments, is within the basic rate tax band. A useful guide on who needs to fill in a tax return can be found here.

Actual rates of tax and calculation

Everybody has a Personal Allowance. For the 2005/06 tax year this is £4,895. This is the tax free band. If your income is below this, no tax is payable.

Those over 65 may receive a higher Personal Allowance but only if their annual income is below £19,500 (this income level applies to 2005/06 only). Above this level the additional allowance is gradually withdrawn until they have the same allowance as those under 65. Also, those who are married and over 65 may get a married couples allowance too.

Once your income exceeds the tax-free Personal Allowance figure, we have in place a cumbersome and excessively complex series of tax bands, which vary depending on the type of income.

Let's look first at the primary rates. These will apply to earned types of income, principally from employment, self employment and pensions. Remember, these rates are applied to any income over and above the tax-free Personal Allowance. The rates go up on a sliding scale the more you earn. So, using the official descriptions:

• Starting rate of 10% on income up to £2,090;
• Basic rate of 22% on income between £2,091 and £32,400; and
• Higher rate of 40% on income over £32,400.

Bearing in mind that these income tax rates are applied to the income after deducting the tax-free Personal Allowance, it follows for example that, say, an employed person with no other income could receive (£32,400 + £4,895) = £37,295 this tax year before paying higher rate tax.

The actual tax due would be calculated as follows:

The first £4,895 of income is the Personal Allowance and is therefore taxfree. The next £2,090 is taxed at 10% (tax of £209). The next band of income between £2,091 and £32,400 is taxed at 22% (tax of £6,668). The total tax payable would therefore be £6,877 (£209 plus £6,668).

Note that the tax rates are marginal. That is, they are applied only to the band of income concerned and do not apply to the whole income. Thus if the above individual receives an additional £1 income, the tax rate would be at the higher rate of 40% on that pound alone. It does not bring the whole of the income into the higher rate band.