Income Tax: Everything You Need to Know

Income tax is charged on most forms of income, but the way you pay depends on your employment.

Rebecca Goodman Published on 17 December 2020. Last updated on 20 January 2021.
Income Tax: Everything You Need to Know

What is income tax?

Income tax is collected on most of the money we receive, including wages we earn from a job and income from state or private pensions. The government uses taxes to fund public spending.

Some people may also pay tax on benefits they receive through their job — such as a company car or medical insurance — on some state benefits, and also on some interest earned through savings accounts. If you let a property, your rental income may be subject to income tax as well.

The amount of income tax you pay depends on the size of your overall income, and it works differently if you’re self employed.

Here we explain how it works, how much you need to pay, and where the money goes.

How does income tax work?

The personal allowance is set on a yearly basis, and is usually confirmed in the budget. It will be £12,570 from April 2021 and, as per the announcement in the Budget 2021, it will remain frozen at this level until April 2026.

The higher-rate income tax threshold will be £50,270 from April 2021 and will also stay the same until 2026.

If you earn more than £100,000 a year, your personal allowance will be reduced by £1 for every £2 over that threshold. As such, once you earn £125,000 a year you no longer have the benefit of a personal allowance and all of your income is subject to income tax.

Does everyone pay income tax?

The majority of us will pay tax on any money we earn or are given, but there are some exemptions, including the following:

  • The first £1,000 earned if you’re self employed.
  • The first £1,000 of rental income if you rent out a property.
  • If you rent out a room in your home, no tax is paid on the first £7,500 you earn.
  • Any interest earned on savings accounts that are exempt from tax, including individual savings accounts (ISAs).
  • Dividends earned from company shares, up to a yearly allowance, which is currently £2,000. However, share dividends can be totally exempt from income tax if they are held within a tax-free wrapper, such as a stocks and shares ISA.
  • Some state benefits, including child benefit.
  • Money won through premium bonds or the National Lottery.

How much is income tax?

From April 2021, you will pay income tax on any earnings from £12,570 to £50,270 a year, it is charged at the basic rate of 20%, and then from £50,271 to £150,000 it’s set at the higher-rate of 40%. An additional rate of tax is charged on anything earned over £150,000, and this is 45%.

This is the case for the whole of the UK apart from Scotland, where the starter rate is 19% on income between £12,570 and £14,667. Thereafter, this rises to the basic rate of 20% on income up to £25,296 before increasing again to the intermediate rate of 21% on incomes up £43,662. The higher rate of 41% is set on earnings of £43,662 up to £150,000. Any earnings in excess of £150,000 are subject to a top rate of 46%

How do I pay income tax?

The way you pay income tax depends on your employment. Everyone has a tax code that explains how they need to be taxed.

The majority of people pay via Pay As You Earn (PAYE), and this way tax is automatically taken from your wages or pension provider before you receive the rest of the money.

Those who are self-employed and some higher earners pay tax a little differently. They need to fill out a self-assessment tax return once a year and manually make a payment to HM Revenue & Customs (HMRC) for their tax and national insurance.

Where does the money go?

Money collected through income taxes goes to a wide-range of areas of public spending.

In last year’s government report, wealth, state pensions, healthcare and education were the areas where the majority of the money went. But tax helps fund other areas including defence, transport, culture, overseas aid and environmental issues.

About the author:

Rebecca Goodman is a freelance journalist who has spent the past 10 years working across personal finance publications. Regularly writing for The Guardian, The Sun, The Telegraph, and The Independent. Read more

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