What is income tax?
Whether you’re self-employed or running a company, you’ll need to know about income tax. Click here to learn what it is, and how to pay it
Many people don’t really like to think about income tax. Their payslip arrives, money is taken out, and they get on with their lives. However, if you’re self-employed or running a company, then you really do need to think about income tax.
For companies, not taxing your employees correctly could get you in serious trouble with HMRC.
And for the UK’s legions of self-employed workers, every January brings the stress of making sure a self-assessment tax return is filed correctly before midnight on the 31st.
Most manage to submit it on time, but in 2020, almost one million people missed the deadline – and were therefore liable for penalties that start at a £100 fine.
To make sure income tax doesn’t ruin your day, this guide will cover the following:
Do I need to pay income tax?
Income tax, as you might expect, is tax you pay on your income. However, it’s not quite as straightforward as it sounds. Your ‘income’ can come from a variety of sources, some of which are taxable and some of which are not.
You’ll need to pay income tax on the following income sources:
- Employment – For most people, this will be a salary, but self-employed income is also taxable above a certain level.
- Most pensions – Including state pensions, retirement annuities, company pensions, and personal pensions.
- Rent payments – The only exception to this is live-in landlords who receive less than the rent a room limit, and landlords whose rental income is under £1,000 a year.
- Savings interest – When this exceeds your savings allowance.
- Some state benefits
- Income from a trust
- Employment benefits
You also won’t pay income tax below a certain level of income. This is what’s known as a personal allowance.
How much is income tax?
The amount of income tax you pay depends on your annual income, i.e. how much money you make in a year from the sources discussed above. This amount is explained in the following table:
|Annual Income||Income tax rate||% of income tax payers|
|£0 - £12,500||0%||N/A|
|£12,501 - £50,000||20% (Basic rate)||85%|
|£50,001 - £150,000||40% (Higher rate)||14%|
|Over £150,000||45% (Additional rate)||1%|
These rates apply to England and Northern Ireland. The income tax rates in Wales are set by the Welsh Government, although for the 2019/20 tax year, these rates are the same as for England and Northern Ireland. In Scotland however, Scottish income tax rates apply.
What is a personal allowance?
Despite its rather mundane name, the personal allowance is actually rather exciting.
In short, if you earn under a certain level, then you won’t need to pay any income tax at all.
For the 2019/20 tax year, the personal allowance is £12,500. However, this has historically been changed fairly regularly by governments, so make sure to check the correct Personal Allowance level on gov.uk.
Moreover, this level applies to everyone, and you’ll only be taxed on what you earn above it.
There are some factors that may affect the size of your personal allowance. Claiming Marriage Allowance or Blind Person’s Allowance may increase it, while it may be reduced if you owe tax from a previous year.
The other key consideration is for those with income over £100,000 a year. At this level, the personal allowance is reduced by £1 for every £2 earned. Therefore, if your annual income is £125,000 , you’ll have no personal allowance and be required to pay the relevant amount of income tax on the entire amount (in this case, 40% tax on £125,000, which is £50,000).
It’s important to remember that there are some forms of income which are not subject to income tax. The main examples are:
- The first £1,000 of self-employed income – This is referred to as the ‘trading allowance’.
- The first £1,000 of income from rented out property (unless you’re renting out a room in your property under the Rent a Room scheme).
- Income from tax-free accounts, such as ISAs or National Savings Certificates.
- Money made from selling shares, property, or other assets (this would fall under Capital Gains Tax).
- Dividend payments under the level of your dividend allowance (which stood at £2,000 as of the 2019/20 tax year).
- Some state benefits.
- Premium bond/National Lottery wins.
National Insurance is another tax paid on employment income and self-employed profits. The key difference is that national insurance is very closely tied to state benefits, and is paid by both employees and employers.
Essentially, the idea is that national insurance is paid into a fund, and this fund then pays for some state benefits. Consequently, if you haven’t made enough national insurance payments, you may be barred from receiving some state benefits.
For most people, national insurance is simply deducted from their pay slip. However, if you’re self-employed, you’ll need to work out how much you need to pay as part of your self-assessment tax return.
Employers should ensure that they make the correct contributions for their employees, and make the correct deductions for their pay.
National insurance contributions are paid by those aged over 16 who fulfil one of the following criteria:
- Employed and earning over £166 a week (if you earn between £118 and £166 a week, you do not need to pay, but you are counted as having paid in terms of eligibility for benefits).
- Self-employed and making an annual profit of £6,365 or more (if you make less than this, you may be able to make voluntary contributions).
For more information, including a full explanation of the rates of national insurance that need to be paid by self-employed people, employees, and employers, see the gov.uk national insurance page.
How do I pay income tax
There are two main ways to pay income tax – employers will need to do it via payroll, while self-employed people will need to correctly work out their income tax payments/national insurance contributions as part of their self-assessment tax return.
Paying income tax as an employer
Full guidance on how to ensure you’re paying your staff correctly is given in our ‘How to pay employees in a small business’ guide, but there are six key steps you’ll need to follow.
- First, you’ll need to register as an employer with HMRC to get your PAYE (Pay As You Earn) employer reference number, so you can use the PAYE Online system.
- Select and install payroll software, as this will help you record the details of your employees, calculate the appropriate pay/deductions, and submit this data to HMRC. For a great insight into the best systems available, check out our payroll software comparison guide.
- Collect and keep records that show amounts paid to employees, deductions, and other important information like tax code notices.
- Tell HMRC about your employees – for every employee, HMRC needs to know important information like their right to work in the UK, their student loan status, their national insurance number, their date of birth, their gender, their full address, and the date they started working for you.
- Record pay, make deductions, and submit a report to HMRC – this needs to be done on your first payday and every subsequent payday.
- Pay HMRC the income tax (and national insurance) owed on your employees
Paying income tax if you're self-employed
Again, our guide to completing a self-assessment tax return offers more detailed guidance, but here are the key steps to follow:
- The first step is to register as self-employed with HMRC. Once you’ve done this, HMRC will send you a letter that includes your 10-digit Unique Taxpayer Reference (UTR) number, and create an account that lets you access the Self Assessment online service.
- Use the online service to file your tax return for the correct tax year (tax years run from 6 April in one year to 5 April the following year).
- If you’re submitting your tax return online, then you’ll need to file by the 31 January (paper forms must be submitted by 31 October in the previous year).
- As part of this process, you’ll need to accurately submit details of your income and business expenses, so you can accurately work out how much income tax and national insurance you need to pay. Make sure you keep those receipts and invoices!
- Finally, pay any tax owed.
Everyone needs to know about income tax – even if it’s just so you understand why money is taken out of your salary every month.
In this guide, we’ve explained what income tax is, looked at how it’s affected by the personal allowance, advised on what counts as taxable and non-taxable income, and given a good idea of how much income tax you’ll need to pay at different income levels.
We’ve also briefly looked at national insurance, given advice on registering and paying income tax as an employer and a self-employed worker, and provided plenty of handy links that will explain everything you need to know about this fundamental facet of working life.