How the income tax system works

ScotiaAccounting  |  5th August

This blog is aimed at those who have little or no experience when it comes to income tax.

Due to the downturn in the UK economy over the past few years, society has now taken a keen interest in their personal income and the ways in which income is taxed by the government.

I thought it would be beneficial to give a brief explanation of how the income tax system works.

For an individual there are three main sources that are taxable:

  1. Non savings
  2. Savings
  3. Dividend

Non Savings

This is where the majority of people are taxed. It includes income from employment, trading and property rental for example.

Savings

Savings income is interest gained from bank/building society accounts.

Savings

Interest on savings are subject to taxation each year

Dividends

This is simply income received from dividends (a lump sum paid out of a company’s profit).

There is a collective threshold of £32,010. Income below this figure is taxed at the basic rate of 20%. If this threshold is exceeded then income will be taxed at the dreaded higher rate of 40% (there are various methods which can be implemented to avoid paying tax at 40%). Income above £150,000 is taxed at 45%.

In addition the first £2,790 of savings is taxed at 10%.

Take note that dividends are taxed lower at 10% up to £32,010 and 32.5% over. This is one of the advantages of setting up a limited company as directors who have shares in the business can pay themselves a dividend from the accumulated profit the company has earned.

Everyone is entitled to a personal allowance. If under the age of 65 years the personal allowance currently stands at £9,440. A personal allowance is the amount received by an individual tax free. This is deductable from an individual’s income therefore reducing their tax liability.

A quick example

Homer has trading income of £22,000 and property rental income of £5,000.

His taxable income will be £17,560 (£22,000 + £5,000 – £9,440).

His tax due will therefore be £3,512 (£17,560 @ 20%).

Homer Simpson

Ignoring your tax position can creep up on you at unexpected times.

The UK tax system is long, winded and increasingly complicated with ongoing changes in regulations. If you are looking to set up in business whether it be as a sole trader, renting out property or setting up a limited company always seek advice on tax no matter how small you may think your query is.

I hope this brief introduction has given you an insight into how your income is taxed.

If you have any comments and/or questions  please feel free get in touch.