Explained: How UK Income Tax Works

Have you ever wondered how your hard earned cash is actually taxed?

Well, wonder no more!!!

In this post I lay out how UK income tax works and what it means to you.

Myth Buster 101

In a recent poll on my Instagram page, 30% of the respondents believed a higher rate tax payer only pays 40% Income Tax.

So, if you only take one thing away from this post, let it be this:

Myth Buster: Income Tax in the UK is tiered! Being a higher rate taxpayer does NOT mean all of your income is subject to 40% tax!!

A higher rate tax payer has three different tax bands!

(For folk residing in Scotland, the tax bands are slightly different but the principles throughout this post are the same… don’t worry, I’ll clue you in!).

Types of Income

In the UK, Income Tax applies to some types of income but not to others.

I’ll give you the highlight reel and provide links to HMRC, for those who want a full breakdown, at the end of the post.

You pay Income Tax on:

  • Earned income (via PAYE)
  • Rental income
  • Self-employed profits
  • Pension income (sometimes)

You don’t pay Income Tax on:

  • Income from an ISA
  • Lottery winnings 🥳
  • Premium bonds

Check the links at the end of the post if you want a full breakdown!

Personal Allowance

Everyone starts with a standard Personal Allowance of £12,570, which is the amount you can earn tax free each year 🙌

(The allowance does typically increase each tax year, however at the time of writing the government has frozen the Personal Allowance until the 2025/26 tax year).

For some, their Personal Allowance can be increased/decreased/removed – however, we’ll save those technical aspects for another day.

The goal is to simply explain UK Income Tax, so I’ll keep it as high level as possible!

Tax Bands

Let’s have a look at the tax bands, using a trusty bucket to illustrate them:

how UK income tax works
a bucket showing the different income tax bands for England, Wales and Northern Ireland 
0%, 20%, 40%, 45%

As mentioned, the Scots have altered their tax bands slightly!! I’ll show you them now, then for the rest of the post I’ll only use the ones above (the principles remain the same):

how UK income tax works
a bucket showing the different income tax bands for Scotland
0%, 19%, 20%, 21%, 41%, 46%
(I have no idea why they felt the need to confuse things!!)

So, as you can see, UK Income Tax is tiered. We only pay the specified tax rate on the amount that falls into a particular band, lovely!!

Let’s have a look at a couple of examples by filling up our bucket to different levels:

how UK income tax works
a bucket being filled with £30,000 of income, showing it fills the 0% tax band and some of the 20% tax band
total income tax = £3,486

The first £12,570 is tax free, leaving £17,430 (£30,000 – £12,570) subject to 20% Income Tax.

Now, before you get too excited, you also have National Insurance (NI) contributions to pay on the £30,000 income (we’ll leave the mechanics of NI for another day, I just want to remind you it exists).

Right. Let’s whack up the income level!! £60,000 income detailed below:

how UK income tax works
a bucket being filled with £60,000 of income, showing it fills the 0% tax band and 20% tax band and some of the 40% tax band
total income tax = £11,432

Again, you pay no tax on the first £12,570.

This time you’ve filled up the 20% band!

At the current level, £37,700 fits into the 20% tax band… which means you can earn £50,270 (£12,570 + £37,700) without paying over 20% Income Tax 🤑

As you’ve maxed out the 20% band, the remaining income overflows into the 40% tax band.

In this example, only £9,730 of the £60,000 income is subject to 40% tax 🙌

To Recap

  • The first £12,570 you earn is (typically) tax free.
  • UK Income Tax is tiered! You only pay higher rates on some of your income.
  • Scotland has different tax bands, but the principles remain the same.
  • Don’t forget about National Insurance!

If you are still a bit unsure, think of each tax band as its own bucket:

how UK income tax works
4 buckets, with income cascading between them

You fill up each bucket with taxable income until it overflows and then you begin filling up the next one 🪣

At the end of the post I’ve linked an income calculator for you.

ISAs & Pension

I’ll keep this section brief, as I could write endless blog posts on these accounts!

ISAs:

  • Any money you put into an ISA is sheltered from any Income Tax or Capital Gains tax.
  • You could invest £10,000 within an ISA, turn it into 1 million quid and withdraw all of it tax free!!! No Income Tax. No Capital gains tax 🤑
  • However, beware those that say an ISA is ‘tax free‘ – that is incorrect!
  • An ISA is still subject to inheritance tax (IHT) ☠️

Pensions:

  • 25% of the pension pot is tax free 🤌
  • 75% is subject to Income Tax (at the point of withdrawal).
  • Money within a pension is not subject to IHT.
  • Pensions are complex 🧪
  • Check out my post Wealth Creation Machine, to find out why you need a pension 🤝

Typically speaking, a generic withdrawal strategy as you approach/enter retirement is to use up your ISAs first (as they are free from Income Tax and reduce the size of your estate), before moving onto your pensions… but remember, you are not generic and it will depend on your circumstances 🤝

More Allowances?!

Another quick fire section 🔥

HMRC kindly grant us more tax free allowances than just the Personal Allowance!

The main two to be aware of:

  • Savings allowance = basic rate tax payers can earn £1,000 in interest before paying any tax. For higher rate earners it drops to £500 and additional rate earners do not get the allowance.
  • Dividends allowance = we can all receive £2,000 in dividends tax free each year 🕺

As the UK tax system is complex, there are of course caveats and other fun allowances you may wish to be aware of – again, I’ll link to HMRC for a full breakdown at the end of the post.

Dividends 🤑

Tom, WTF is a dividend?! I hear you say!

Dividends are taxed differently to earned income:

  • Basic rate = 8.75%
  • Higher rate = 33.75%
  • Additional rate = 39.35%

Remember, you only pay tax if you’ve used up your £2,000 dividend allowance!

You’ll note that the dividend bands are lower than that for earned income. Business owners routinely take a low salary and then top up their income via dividends – it’s more tax efficient 🤓

60% Tax Band 🤯

The following section only relates to people who earn over £100,000. Feel free to skip it!

For those brave enough to stay, welcome to the Danger Zone a.k.a Death Valley ☠️

(You may also see this referred to as a ‘tax trap’ or ‘tax sinkhole’).

Whilst Income Tax rates only go up to 45%, you can end up paying an effective rate of 60% Income Tax!!

How does this happen?

It all comes down to the Personal Allowance.

Within the tax rules, it states:

Your Personal Allowance goes down by £1 for every £2 that your adjusted net income is above £100,000. This means your allowance is zero if your income is £125,140 or above.

HMRC

Due to the loss of your Personal Allowance, HMRC take £60 from every £100 you earn within the Danger Zone of £100,000 to £125,570 😬

Regaining the Personal Allowance

Now, it’s not all doom and gloom!! You may be able to get some/all of it back 🤭

This area is complex, so please note this is a VERY basic example:

  • You earn £120,000.
  • Therefore, your Personal Allowance is only £2,570.
  • As luck would have it, you have £16,000 cash in the bank.

If you contribute the £16,000 into your pension, your adjusted net income will be reduced to £100,000 – reviving your Personal Allowance to £12,570 🥳

Why only £16,000?

Personal pension contributions attract tax relief from HMRC (20%), so the £16,000 contribution would benefit from £4,000 tax relief – bringing the total to contribution to £20,000 (this process is referred to as ‘grossing up‘).

To top it off, as a higher rate payer you can claim another 20% tax relief via self assessment or a change in your tax code!

You’re left with a lower tax bill, more money invested for your future and tax relief 🙌

Links

Income Tax calculator – click here.

Income Tax rates and Personal Allowances – click here.

Taxable income – click here.

Tax on savings interest – click here.

Tax on dividends – click here.

Intro to National Insurance – click here.

Adjusted Net Income – click here.

Conclusion

The UK tax system is complex and full of caveats and disclaimers, which makes attempting a simple overview quite tough!

For many of us, the first two sections are the most important to understand.

Remember, UK Income Tax is tiered.

I hope you found it useful and now understand how UK Income Tax works 😁

Thanks for reading,

Tom Redmayne, DipPFS 👋

Tax Connoisseur & Simplification Enthusiast


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2 thoughts on “Explained: How UK Income Tax Works

  1. Nice post.

    On the following example, though, to clarify, assuming the £20k sitting in your bank is contributed to a SIPP – you only need to contribute £16k to the pension scheme. This is topped up by HMRC to £20k with basic rate relief into the SIPP and £4k reclaimed through self assessment (if complete one already) or tax code change (if don’t).

    “You earn £120,000.
    * Therefore, your Personal Allowance is only £2,570.
    * As luck would have it, you have £20,000 cash in the bank.
    If you contribute the £20,000 into your pension, your adjusted net income will be reduced to £100,000 – reviving your Personal Allowance to £12,570

    1. Hi Dean, thanks for highlighting this, much appreciated! I’m pleased to hear you enjoyed the post 🙂

      I’ve updated that section.

      All the best,
      Tom

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