Transcription
This is a beginner's guide to how income tax works. I'm Martin Lewis from moneysavingexpert.com. Now, this is a thorny, complicated subject, but I want to try and keep it as simple as possible.
The first thing to say is most people get a personal allowance. That is how much money you are allowed to earn each year before you pay any tax on it. The typical number is £12,570. So, if you earn less than that, and that's total earnings from work and from a pension or interest on your savings, if you earn less than that, it isn't taxed.
If you earn more than that, some of it is taxed. And the sum of it is crucial. If your allowance is £12,570 and you earn more, it's only the bit above that that you pay 20% tax on. So, let's imagine you earn £13,570. That's £1,000 above the threshold. You pay 20% tax on £1,000. You pay £200 tax. You don't pay 20% tax on the entire amount you've earned. And that happens every time you go above a threshold. You only pay the increased rate on the amount above the threshold.
Why is that important? Because I've actually had some people who say to me, "They've just offered me money. I'm going to get a pay rise. It's going to put me up a tax threshold. I should say no, shouldn't I? Because it means I'll take home less." Incorrect. Earn more, you will take home more. But of course, that what that does mean is the rate above 12,570 is 20%. So every pound you earn above that, you take home 80p after income tax. There's also national insurance, but we're keeping it simple. I'm going to ignore that.
Now, you continue to pay that 20% rate until typically earnings of £50,270 a year. Once you hit that, above that, the tax rate is 40%. So then every pound you earn, 40p is taken off. You take home 60p. But remember that's only on above the threshold.
Now you would think that continues until the tax rate is increased again, which happens and the last tax threshold is at £125,000, but it doesn't because something funny happens once you start to earn 100 grand if you're lucky enough to. Once you get to £100,000, you start to lose your personal allowance. Remember that £12,570 that you can earn tax-free. Once you hit £100,000, each pound over you go, you start to lose the personal allowance. And what that effectively means is from earnings from £100,000 to around £125,000, your effective tax rate is 60%. In other words, for every pound you earn in that threshold, you only take home 40p.
Then finally, we get to the top rate of tax, which is for people generally who earn over £125,140. By the way, all these tax thresholds are England, Wales, and Northern Ireland. It's slightly different in Scotland, but the principle is the same. Above £125,140, the rate is 45%. Which means for every pound you earn, you would take home 55p.
So this is a little bit quirky if you think about it. Up to £12,570 no tax. 12570 to around £50,000. On that bit, you pay 20%. Then above 50 grand up to 100 grand, you're paying 40%. From 100 grand up to £125,000, you're effectively paying 60%. And then above £125,000 on money earned above that, you're paying 45% in tax.
Final thought before I go on this, there have not been headline income tax raises for a couple of years because what's actually happened is they've increased income tax revenue via a stealth tax which is called fiscal drag. Now that isn't when chancellors wear rouge. What fiscal drag means is they have frozen all of those thresholds. So let's take the basic personal allowance, the £12,570. If you were earning under that before and your income has increased due to earnings going up and earnings have gone up and inflation gone up and it puts you above the threshold and they haven't moved the threshold, suddenly you start paying tax on your earnings while you haven't before. Even though prices have gone up, inflation means prices have gone up, which effectively means your earnings are going to be taxed on the same equivalent rate because all prices have gone up so with inflation than they were before. And that has happened at every threshold level. And this fiscal drag freezing the thresholds is the way that the current government, the Labour government and the past Conservative government have increased revenue from income tax without changing the tax rates.
Now that is a very basic one-on-one 101 rather on income tax. I hope it makes sense. There are a lot more complexities and I haven't factored in national insurance which is effectively a form of income tax too. But I just wanted to give you a beginner's.