Understanding your personal income tax

Last week I have written a post about property income tax. As I was writing it, it dawned on me, that I should write a whole series of posts about personal tax. After all, for tax purposes, we can't separate our income streams. Instead, according to HMRC rules, all our income should be added together to calculate the tax that we owe to them. That's why in this post I will briefly explain how to treat each type of income and how and when to inform HMRC about it, as well as how to prepare yourself so that the tax amount will never come as a big surprise again.

If your only income is from employment, then you don't have to worry about calculating your own tax at all, as it is all done for you, and a portion of your tax is taken away from your salary every month through the PYAE system. However, if you work as self-employed, are a landlord, or have some savings or investments that bring you income, you have to report your income to HMRC and pay it by yourself.

When you report your income to HMRC using their online self-assessment service, the tax will be calculated for you, after you provide them with some information about your income, expenses and others. HMRC even has got a service that helps you to find out if you have paid the right amount of tax in previous years by calculating it for you (here), as well as there are plenty of websites offering your income tax calculations, so you will never have to actually calculate your tax yourself.

This post is mostly intended to give you an idea of how tax is calculated so that you can understand it and plan your finances better, so you don't get surprised next time when your bill from HMRC comes.

Please be mindful of the fact, that it is impossible to mention all the tax rules in this short post and therefore it should not be treated as advice. Please remember it's always best to seek the advice of professionals like an accountant or tax adviser, based on your individual circumstances.

First things first, It's important that you understand different types of personal tax.

Personal Income for tax purposes can be divided into four categories:

• Property Income

• Trading Income

• Savings and Investment Income

• Employment, Pension and Social Security Income.

All these categories of income must be reported in a self-assessment tax return if you are registered for it. Self- assessment can be filled online on HMRC's website, and if you choose to do it digitally, the deadline is 31st of January following the year-end on 5th of April. That means, that you have 9 months to fill it. Payment has to be done that same day unless you are paying your tax in instalments.

There are also other types of personal tax. The two most important to be aware of are:

• Inheritance tax ( IHT)

• Capital Gains Tax (CGT)

You can pay CGT on most types of capital gain (excluding sales of property) together with any balance of Income Tax, but IHT is paid separately from other forms of tax, and it depends on when did you inherit the equity. We will not talk about Capital Gains and Inheritance Tax in this post, however, it's good to be aware of these, and that they are separate from Personal Income Tax

So, how do I work out my tax?

1. Start by adding up all your General Income.

That's income from Employment, Pension and Social Security, Trading Income and Property Income. If you have property or trading income, but it's less than £1000 for each of them separately, you don't have to add it to your income calculation as it's covered by trading and property income allowances (you can find more about allowances on HMRC's website).

2. Work out which tax band do you fall into.

Once you have calculated your general income, add your income from savings and dividends to work out which tax band do you fall into.

Tax bands in the year 2020/2021 are as follows:

Basic rate: income from £12,500 to £50,000

Higher rate: income between £50,001 and £150,000

Additional rate: on income over £150,000

This is important to find out if you have saving income, as allowances on that income depend on your overall tax band.

For up to date information on tax bands visit HMRC's website.

3. Workout if you are eligible for personal savings income allowance

Personal saving allowance is currently £1000 for basic rate tax payers and £500 for people paying higher rate tax. Additional rate tax payers are not eligible for the personal savings income allowance.

4. Now you can calculate your tax on general and savings income, taking into consideration all the allowances.

Tax rates on General Income and Saving Income in the year 2020/2021

Personal Allowance: 0% on income up to £12,500

Basic rate: 20% on income from £12,500 to £50,000

Higher rate: 40% on income between £50,001 and £150,000

Additional rate: 45% on income over £150,000

Worth noting:

If your income is above £100,000, your personal allowance goes down by £1 for every £2 of income above £100,000, until zero if you earn £125,000 or more.

Up to date rates on HMRC's website.

5. Now it's time to calculate your tax on Dividends Income.

Tax on the dividend is at a different rate than general income and savings income. That's why we need to calculate it separately.

It's important to note that, although you have to calculate the dividends income tax separately, you need to use the appropriate rate, depending on which tax bad does your overall income place you.

Dividends income tax rates for the year 2020/2021

Dividend ordinary rate: 7.5%

Dividend upper rate: 32.5%

Dividend additional rate: 38.1%

Let's see how is tax calculated on an example

General Income: £49,500

Savings income: £7,500

Dividends income: £5,000

Total income: £62,000

This income places you in the higher tax rate band. That means you can only receive a £500 personal savings income allowance.

Tax calculation will be as follows:

General income and savings income = £57,000

Minus savings allowance= £56,500

We will deduct personal allowance form the base rate band income first.

Income in basic rate = £50,000 - £12,500 = £37,500

Tax @ 20% = £37,000 x 20% = £7,500

Tax @ 40% = £6,500 x 40% = £2,600

We have stopped our calculation here at the higher rate band, that's why the dividend tax will be calculated starting from this rate. In this example, the income does not exceed the upper limit of the higher rate band, and that's why all dividend income will be calculated at the dividend upper rate.

Dividends income = £5,000

Tax @ 32.5% = £5,000 x 32.5% = £1,625.00

Add all tax together

£7,500 + £2,600 + £1,625 = £11,725.00

If some part of the general income in this example came from employment, the corresponding tax would have already been paid. However, if this person is not employed and all their general income comes from trading as self-employed, this amount will have to be paid in full.

As you can see, tax payment can come as a big surprise to someone who didn't plan it and calculated it ahead.

As promised I will share with you a quick tip on how to never be surprised by the HMRC tax bill ever again. Simply put away every month 20% of any of your income which is not salary or pension, into a separate saving account that you will only use for your income tax payment. This way you will always be prepared by having a sum ready to pay your tax. Putting money aside at the rate of 20% will give you an amount higher than your tax liability if your income is lower, due to personal allowance (which can be a nice surprise in the end when you get to pay out yourself a small bonus for being prepared in advance), but as your income grows, this will not be enough to cover all your tax liability. You might then want to be putting aside more than that. Until then 20% will be good enough to keep you stress-free, come January the 31st.