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What is income tax?

Income tax is something you must deal with if you have any sort of income. But do you really understand what rate you are charged? Or what your National Insurance contributions should be?

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Here we break down all you need to know about income tax.

What is income tax?

Income tax is quite simply tax that you pay on your income. Now, income is not purely money that you earn from an employer; it can also be profits from being self-employed, pensions, rental income, income from a trust, or interest on savings over your personal savings allowance (discussed below).

What are allowances?

The key is that you don’t pay income tax on all of your income. This is because you will qualify for different types of allowances – essentially, amounts of otherwise-taxable income that you can have tax-free each tax year.

Allowances include:

Personal allowance – This is the amount you can earn before you are required to pay income tax. In the current tax year (2019–2020), this stands at £12,500.

The upper income threshold for the personal allowance is £100,000. For every £2 you earn above the threshold, your personal allowance will be reduced by £1 until it reaches £0. So if your income is £125,000 or above, your personal allowance will be zero.

Marriage allowance – The marriage allowance is a government scheme that allows you to transfer a set amount of your personal allowance to your spouse or civil partner if he or she earns more than you. This allowance is currently £1,250. In order to qualify, one of you needs to be a non-taxpayer (usually earning less than the personal allowance) and the other partner needs to be a basic-rate taxpayer.

Personal savings allowance – This allows every basic-rate taxpayer to earn £1,000 in interest per year without paying tax on it. If you are a higher-rate taxpayer (which we will cover in a moment), you are only able to earn £500 interest per year tax free. If you are an additional-rate taxpayer, then you do not get an allowance.

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Dividend allowance – If you receive a dividend payment from shares in a company, you only pay tax on those that take you above your allowance for the tax year. In the 2019–2020 tax year this stands at £2,000.

What will my rate of income tax be?

How much income tax you are required to pay depends on your income. If your total income is below the personal allowance of £12,500, then you won’t pay income tax. Let’s break down the different tax-rate thresholds above the personal allowance:

Basic rate (20%) – This applies to anyone who earns between £12,501 and £50,000. It is worth noting that because of the personal allowance, you only pay tax on your income above £12,500.

Higher rate (40%) – If you earn between £50,001 and £150,000, you will be a higher-rate taxpayer. Once again, the rate of 40% is not applied to all your income; you only pay 40% on income of £50,001 or more.

Additional rate (45%) – If you are lucky enough to earn over £150,000, then you will be charged an additional rate of 45% on anything you earn over the threshold.

What about National Insurance contributions?

National Insurance (NI) contributions are usually mentioned alongside income tax, so let’s explain. NI contributions are a tax on your earnings to help build up your entitlement to certain state benefits, such as the State Pension or Maternity Allowance.

NI is not an annual tax; it is instead applied to your pay each pay period. In the 2019–2020 tax year, you begin paying NI once you earn more than £166 a week. How much you pay is once again decided by how much you earn. Currently, the rate is 12% of your weekly earnings between £166 and £962 a week, and 2% of your weekly earnings above £962.

In order to be eligible for the full new State Pension, you will need to have 35 years worth of qualifying NI payments. In some circumstances, you may want to consider making class 3 voluntary NI contributions in order to boost your pension entitlement – for example if you are self-employed but have low profits, or if you are employed but earn below the personal allowance threshold for income tax.

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