FOOL SCHOOL
Understanding Income Tax - Part 1

October 11, 2004

Over the next three weeks the Fool School will provide a brief introduction to the main types of taxation. We kick off with income tax. Today we look at the basics. A second article on Wednesday will look at the taxation of interest and dividends.

Income tax is by far the most common of the direct taxes upon individuals, which almost everybody in the country will pay at some point in their lives. It's the most wide-ranging direct tax of the lot.

As the name tells you, its purpose is to extract tax from the incomes of individuals and, for those of you who actually check your monthly pay slips, you'll know it can be pretty painful to see just how much the Government is taking of your hard-earned moolah.

These incomes arise from several areas, of which the most common are:

• Employment
• Pensions
• Self Employment
• Investment Income

The first three are self-explanatory. Your 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.

The first point to bear in mind is that income tax is levied for a tax year, sometimes also known as a fiscal year or year of assessment. For most people, their eventual income tax liability in any tax year is based upon what they earned in that year. This year commences on the 6 April and ends on the following 5 April.

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 Pay-As-You-Earn (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, the Inland Revenue 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.

The above is an extremely crude and oversimplified idea of the structure.

Actual Rates of Tax and Calculation

Everybody has a Personal Allowance. In 2004/05 this is £4,745. 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 £18,900. Above this level the additional allowance 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 £2,020
• Basic rate of 22% on income between £2,021 and £31,400
• Higher rate of 40% on income over £31,400.

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 (£31,400 + £4,745) = £36,145 this tax year before paying higher rate tax.

The actual tax due would be calculated as follows:

The first £4,745 of income is the Personal Allowance and is therefore taxfree. The next £2,020 is taxed at 10% (tax of £202). The next band of income between £2,021 and £31,400 is taxed at 22% (tax of £6,464). The total tax payable would therefore be £6,666 (£202 plus £6,464).

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.

> Part 2