Income tax is not a complex tax but many of us may not have been aware of how it works before we really start to look into it, and I would include myself in this.
Income tax is devolved in Scotland and the income tax bands and rates are different, but the principles still apply. However, in this article I will be talking about income tax as it stands for the rest of the UK for the year that ends on the 5th of April 2020 and then discussing the proposals for how it will change after the upcoming election.
Let’s start with the personal allowance. This is an amount that everyone gets for which their income is tax free. The amount of the allowance does start to decrease when your total earnings exceed £100,000 but for most of us, it will be £12,500 for the current year. This means that the first £12,500 you earn each year will be free of tax.
The first graph shows salaries up to £10,000 per year. All of this falls within the personal allowance, so anyone on these incomes pay no income tax. However you will see that there is a small amount of National Insurance being paid on a salary of £10,000. This is because National Insurance contributions begin when your salary reaches £8,628. It is paid at 12% over this (so 12p from every additional pound above this value).
The personal allowance may change each year. It is due to remain the same in the 2020/21 tax year, however last year the personal allowance was £11,850. This means that someone earning more than the personal allowance this year has an additional £650 tax free in the current financial year. They would have therefore saved tax of 20% on £650, meaning they will be paying £130 less tax.
If you are employed, your employer won’t just start taxing you when your earnings for the year have totalled £12,500 but will instead tax you monthly or weekly on the assumption you will earn the same amount each period. This way your tax-free allowance is spread across 12 months and you don’t start getting large tax deductions towards the end of the year. One consequence of this is that if you leave your employment part way through the year you may have paid more tax than required and will be due a rebate.
After the £12,500 personal allowance, you are taxed at 20% of your earnings. This is what is called the basic rate band. This rate applies until you hit the threshold for the higher rate of tax which is currently £50,000. So any income between £12,500 and £50,000 incurs tax at 20%.
This next graph shows incomes between £10,000 and £60,000. You can see that as the income increases, so does the amount of tax and national insurance that is paid. This is because on each additional pound, you are paying national insurance at 12% and income tax at 20%. The amount you take home continues to increase, but so does the amount that you pay to HMRC.
After £50,000 you will start to pay tax at the higher rate of tax which is currently 40%. However, this is only 40% on any income over £50,000. For example if you earned £50,001 you would only pay the 40% rate on the £1 which is over £50,000, therefore 40p.
The graph below shows this happening. However, when you hit £50,000 your national insurance contributions drop from 12% to 2% which was missing from the graph that I shared previously. So the amount paid in total to HMRC at the basic rate is 32% and at the higher rate it is 42%.
So for each additional pound you earn, you will be taking home 68p at the basic rate and 58p at the higher.
The higher rate applies until you earn £150,000 at which time you move onto the additional rate of tax for anything over this amount, which is currently taxed at 45%. As the same principles apply, I won’t go through an example of this.
Reducing your tax burden
In order to reduce your tax bill, certain costs you incurred to earn the money can be deducted.
If you have a rental property, you can deduct costs that you incur on renting it out, or if you are self-employed you can deduct the costs that you incur to make your sales. These will all be deducted before your tax is calculated, thereby reducing your tax liability.
There are ways that you can extend your basic rate band if you make payments into a personal pension, if you donate to charity or if you claim the marriage allowance. These things are useful to know about, but they are topics for another time.
Other forms of income tax
You also need to pay tax on any interest or dividends you receive. These are also classed as income tax but will have certain additional tax free allowances and you can be taxed at different rates.
Election 2019 manifesto promises
I’ll now quickly look at the proposals that each of the main political parties have put in their manifestos for the December 2019 election.
The Conservative Party has said that they will not increase the rate of income tax. It had previously been rumoured that they would reduce the threshold for higher rate tax from £50,000 to £80,000 which would have meant a tax cut of £6,000 to anyone earning £80,000 or more. They have said that they will increase the National Insurance threshold to £9,500. This means that anyone earning £9,500 or more will save National Insurance equal to 12% of the increase, which comes to £104.16 (£9,500-£8,632 x 12%).
The Labour Party have said they will increase tax rates for those over £80,000 to 45% and to 50% for anyone earning over £125,000. What this will mean is an additional 5p out of every pound earned over £80,000 up until £125,000, an additional 10p on every pound between £125,000 and £150,000 and an additional 5p on every pound over £150,000. This image shows how much extra tax would be paid for earnings in £20,000 increments. Someone on £100,000 per year would pay an additional £1,000 over the course of the year. At £150,000 would expect additional tax of £5,375.
Opponents have been claiming that Labour’s policies would cost each taxpayer £2,400. To get this figure they have added up the total increased tax and divided it by the number of taxpayers. As you should be able to see from this table, the additional increase would not fall upon everyone equally but on the higher earners, at least where income tax is concerned.
I won’t discuss the Scottish National Party manifesto because, as mentioned tax in Scotland is devolved and uses different rates and brackets.
The Liberal Democrats have proposed to add 1 pence on the pound for all tax rates. The personal allowance would remain intact but any income within the basic rate would be at 21% rather than 20%, anything at the higher rate would be 41% rather than 40% and the additional rate would increase from 45% to 46%. As you can see from this image, there are increases for salaries at all levels rather than just the top 5% of earners like Labour’s proposals.
The Green Party’s manifesto proposes radical changes to the tax system which are intended to simplify it. Several taxes will be merged into one tax which will affect National Insurance, Capital Gains Tax, Dividend Tax, Inheritance Tax and Income Tax. They will also replace the personal allowance with a universal basic income. This is the biggest change and it will be difficult for me to illustrate one example because of that.
The intention is that current rules incentivise certain behaviours to reduce an individual’s tax liabilities. These proposals would close what could be seen as loopholes.
The Brexit Party’s manifesto makes no mention of income tax.
Some of these manifestos talk about changes to other taxes such as corporation tax and inheritance tax. As I am just talking about income tax and national insurance, I won’t discuss those here.
That’s all for now but if you have any comments or questions, please leave a comment or drop me a message.