What is income tax - how is it calculated and does everyone have to pay it?

Income tax may be automatically deducted from your salary before it hits your bank account, so you may not think too much about it. But alongside national insurance, it is important to understand exactly what income tax is, how it's calculated and why you have to pay it.

With households needing to keep a watchful eye on outgoings with inflation rising and energy bills skyrocketing, knowing what tax you need to pay can be a big help. 

Sarah Pennells, consumer finance specialist at Royal London says: “Income tax was introduced in the UK over 200 years ago as a temporary measure and is still with us today! It’s a tax that does what it says on the tin, in that you pay it on your income – but not necessarily on all your income.”

It is also important to understand the details of your income tax. If your tax code is incorrect you could be paying much more than you need to. If this is the case, you could be due a tax rebate.

What is income tax?

Income tax is a tax that you pay on the money you earn. The amount you pay depends on how much you earn. Essentially, the more you earn, the more you pay. It is collected by HMRC on behalf of the government to help provide funding for public services such as the NHS and education. It’s also used to fund the welfare system, as well as investment in public projects, such as roads, rail, and housing.

There are three income tax rates:

• the basic rate at 20%
• 40% is the higher rate
• 45% is the top rate.

But you don’t necessarily pay one rate on your income. It is tiered. You won't pay any income tax if you earn less that £12,570 per year. (Importantly, thanks to a recent change in the National Insurance threshold, you won't pay any National Insurance either if you earn less that £12,570). 

You’ll currently pay 20% on anything you earn between £12,571 and £50,270 and 40% on earnings between £50,271 and £150,000. Those with an income of over £150,000 pay 45%. But from April 2023, the point at which you start paying 45% income tax rate will be reduced to £125,140. This means more higher earners will be paying more income tax than they did in the current tax year.

Former Chancellor Kwasi Kwarteng had announced a raft of changes to the income tax system in his mini budget on 23 September 2022. These included dropping the basic rate of income tax to 19% and abolishing the top rate. The government u-turned on getting rid of the top rate 10 days after it was announced. The reduction of the basic rate was then scrapped by new Chancellor Jeremy Hunt on 17 October. 

However, a month later, Jeremy Hunt went on to announce more changes to income tax in the Autumn statement. He said: "Asking more from those who have more means that the first difficult decision I take on tax is to reduce the threshold at which the 45p rate becomes payable from £150,000 to £125,140. Those earning £150,000 or more will pay just over £1,200 more in tax every year.

"We are also taking difficult decisions on tax-free allowances. I am maintaining at current levels the income tax personal allowance, higher rate threshold, main national insurance thresholds and the inheritance tax thresholds for a further two years taking us to April 2028."

The freezing of the thresholds ultimately means that for some people, when their wages go up and the tax thresholds don't, they will be moved into a higher tax band and have to pay more income tax. This is what people mean by stealth taxes.

Income tax bands are different if you live in Scotland.

To determine your own level of tax, HM Revenue & Customs (HMRC) issues a personalised tax code. It is made up of letters and numbers and will be displayed on your payslip, P60 as well as on your annual coding notice letter from HMRC.

Understanding your tax code

The first four numbers on your code represent how much you can earn or receive as income before you start paying tax. This is known as your personal tax allowance. The standard personal allowance is £12,570. This would be expressed as 1257 on your tax code as all allowances are divided by 10. Most people should start out with this tax code.

The four numbers are followed by a letter, which refers to your individual tax situation.

Here are some examples:

• L – This is a standard letter and means you’re entitled to the tax-free personal allowance
• N – This will appear if you have elected to transfer 10% of unused allowance to your spouse or civil partner
• OT – This code denotes that all your tax allowances have been used up - with the result that all your income will be taxed. This might be used if you've started a new job and don't have a P45 showing your earnings and tax paid at your previous job.

For a full list of tax codes check on the official government website.

Do I have to pay income tax?

Yes, employees and the self-employed must pay income tax on earnings above the personal allowance. Other types of taxable income include rent from a buy-to-let property, pension withdrawals, and dividends (or cash payout) from shares. However, you don’t usually pay income tax on all your taxable income. This is because most people qualify for one or more tax-free allowances.

Everyone gets a personal allowance, though once your earnings hit the £100,000 threshold, your personal allowance is reduced by £1 for every £2 you earn above it, until it reaches £0. So if you earn £125,000, you pay income tax on the lot, and there’s no tax-free allowance.

There’s also the marriage allowance. This allows you to transfer £1,260 of your personal allowance to your spouse or civil partner if they earn more than you. However, there are eligibility rules - one of you must be a non-taxpayer and one must be a basic-rate taxpayer. Higher or additional-rate taxpayers aren't eligible for this allowance.

Katt Mann, savings and investments specialist at Nutmeg said: “These allowances are worth knowing about. The marriage allowance, for example, could reduce a tax bill by up to £252. It is also worth checking if you are eligible to backdate your claim, in some cases you may be eligible to claim from tax years since 2017.”

Income tax calculator - work out how much you will pay

Calculating tax can be seriously complex, so we have developed a specialised tax calculator to crunch the numbers – so you don’t have to.

Type in your annual salary and the calculator will generate a series of numbers. You’ll be able to view your take-home income per month and per week, once income tax - and National Insurance (NI) - have been deducted. You will also be able to see a breakdown of the income tax and NI applied to your level of earnings.

Once you have a clear picture of your earnings once tax has been taken off, you can understand exactly what you will receive on payday to allow you to be in control of your budgeting.

Bear in mind too, that the 1.25 percentage point National Insurance increase that came into effect in April 2022 will be reversed from 6 November 2022. 

How is income tax paid?

If you are employed, income tax (and national insurance) will automatically be deducted through the Pay As You Earn (PAYE) system. You don’t need to do anything, your employer will take care it. If you’re self-employed, you pay it at the same rate as everyone else. But you pay it a year in arrears through a self-assessment tax return, as well as a ‘payments on account’ which is a twice-year payment towards the upcoming year's tax. These payments are calculated based on the previous year's tax bill. Self-employed workers must have a keen understanding of what they will owe to ensure they keep enough back to cover the tax.

What happens if I work part-time, do I still have to pay it?

Yes, income is subject to tax regardless of whether you work full or part-time. Employees who move to part-time hours with the same employer should not need to take any action provided their PAYE code is correct, as the system should automatically recalculate the tax throughout the year.

It’s important to keep an eye on your tax code if you move jobs or change hours.Kat Mann added: “HMRC will tell your employer which tax code they should use for you, so that your income can be correctly taxed. However, the onus is on individuals to check that their tax code is correct – this can be particularly important when you have a change in salary, if you receive regular bonuses and when you change jobs.”

You can check your tax code with HMRC and if you’re unsure, it can be worth calling to check you have the correct tax code. Even a small error could mean you’re overpaying or underpaying by hundreds of pounds.

Do I still pay if I am on maternity leave?

Yes - if you earn over the personal allowance threshold, you will need to pay income tax when you're on maternity leave. Maternity pay is paid in the same way as your income when you are working - this includes statutory maternity pay (SMP). There’s no alternative rate when you take time off after having a child. If you’re self-employed you’ll need to declare your SMP as earnings and pay income tax on the total.

“If your level of pay is above the personal income tax allowance, then you will pay income tax on your maternity pay,” added Kat Mann. “National Insurance contributions are also deducted.”

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