What is Income Tax?

Income Tax Explained

Income tax is a tax charged on most types of income received by individuals in the UK. It is the government’s largest source of revenue and is administered by HMRC. The legal basis for income tax is found in the Income Tax Act 2007, the Income Tax (Earnings and Pensions) Act 2003, and the Income Tax (Trading and Other Income) Act 2005.

Income tax applies to earnings from employment, self-employment, pensions, rental income, savings interest, dividends, and most other forms of income.

Tax Rates and Bands (2024/25)

Income tax is charged at different rates depending on how much you earn. The rates apply to taxable income — your total income minus your personal allowance and any other deductions.

Personal Allowance Reduction

The standard personal allowance is £12,570. However, it is reduced by £1 for every £2 of income above £100,000. This means the personal allowance is completely eliminated at income of £125,140.

This creates an effective marginal rate of 60% on income between £100,000 and £125,140 — for every £100 earned in this band, you lose £50 of personal allowance (effectively taxed at 40%) plus pay 40% tax on the income itself.

Marriage Allowance

If your income is below the personal allowance, you can transfer up to £1,260 of your unused allowance to your spouse or civil partner, provided they are a basic rate taxpayer. This can save up to £252 per year.

Blind Person’s Allowance

An additional allowance of £3,070 (2024/25) is available if you are registered blind (or severely sight impaired).

How Income Is Taxed

Different types of income are taxed in a specific order, which affects the rates applied:

Non-Savings Income

This is the first layer and includes:

• Employment income (salary, wages, bonuses, benefits in kind)
• Self-employment profits
• Pension income
• Rental income
• Most other earned income

Non-savings income is taxed through PAYE for employees or through self-assessment for the self-employed and those with complex affairs.

Savings Income

Interest from bank accounts, building societies, bonds, and other savings is taxed after non-savings income.

Savings Allowance — basic rate taxpayers can earn up to £1,000 in savings interest tax-free. Higher rate taxpayers receive a £500 allowance. Additional rate taxpayers receive no savings allowance.

Interest within an ISA is completely tax-free.

Dividend Income

Dividends are taxed last, after non-savings and savings income, at special rates:

The dividend allowance of £500 means the first £500 of dividends is tax-free regardless of your tax band.

Understanding dividend taxation is important for company directors who extract profits through a combination of salary and dividends rather than paying full salary subject to National Insurance .

Tax Codes

Your tax code tells your employer or pension provider how much tax-free income you are entitled to. The standard tax code is 1257L, representing a personal allowance of £12,570.

HMRC adjusts tax codes to account for:

• Untaxed income from previous years
• Benefits in kind (company car, medical insurance)
• State Pension
• Reduced personal allowance due to high income
• Gift Aid contributions or pension relief

How Income Tax Is Collected

Through PAYE

Most employees and pensioners have income tax deducted at source through the PAYE system. The employer calculates tax based on the employee’s tax code and deducts it from each payment before the employee receives their net pay.

Through Self-Assessment

Self-employed individuals, landlords, and those with complex tax affairs report their income and calculate tax through self-assessment . This involves filing an annual tax return and paying any tax owed by 31 January following the end of the tax year.

Tax Deducted at Source

Some income has tax deducted before you receive it:

• Bank interest — since April 2016, paid gross (without tax deducted) for most individuals, with tax collected through PAYE code adjustments or self-assessment
• Construction industry payments — deducted under the Construction Industry Scheme
• Certain pension payments

Allowable Deductions

Certain payments reduce your taxable income:

Pension Contributions

Contributions to registered pension schemes receive tax relief:

• Basic rate relief is given at source (the pension provider claims it from HMRC)
• Higher and additional rate relief is claimed through self-assessment or PAYE code adjustment
• Annual allowance of £60,000 (or 100% of earnings if lower)

Gift Aid

Charitable donations through Gift Aid extend your basic rate band, providing relief at your marginal rate. The charity claims the basic rate tax (25% of the net donation) from HMRC, and higher/additional rate taxpayers claim the extra relief through self-assessment.

Employment Expenses

Employees can claim tax relief on certain expenses not reimbursed by their employer, such as:

• Professional subscriptions
• Tools and equipment for work
• Working from home allowance
• Uniform and work clothing

Income Tax and Other Taxes

Income tax is one of several taxes individuals may pay. It is distinct from:

• National Insurance contributions — a separate charge on earnings that funds state benefits
• Capital Gains Tax — charged on profits from selling assets
• VAT — a consumption tax on goods and services
• Corporation tax — paid by companies rather than individuals

Companies pay corporation tax on their profits rather than income tax. However, company directors pay income tax on any salary, bonuses, or dividends they receive from the company.

Scottish Income Tax

Scottish taxpayers pay Scottish Income Tax on their non-savings, non-dividend income. Scotland has different rates and bands set by the Scottish Parliament:

Scottish taxpayers are identified by their S tax code prefix (for example, S1257L).

Record Keeping

Whether your tax is collected through PAYE or self-assessment, you should keep records of all income sources. The Companies Act 2006 and tax legislation require proper accounting records to be maintained. Self-employed individuals must keep records for at least 5 years after the filing deadline, and Making Tax Digital is progressively requiring these records to be digital.