A Guide to Income Tax and National Insurance

A Guide to Income Tax and National Insurance

Income Tax

The 2021/2022 tax year begins 6 April 2021 and ends 5 April 2022 and the following will explain how most individuals will have to pay their income tax:

  • 0% on the first £12,570 (personal allowance)
  • 20% on the next £37,700 (basic-rate band)
  • 40% above £50,270 (Higher-rate threshold)

Basic-rate taxpayer explained

Arun earns a salary of £30,000. This is how his income for 2021/2022 can be calculated:

  • 0% on first 12,570 = £0
  • 20% on the next £17,430 = £3,486
  • Total income tax bill = £3,486

Higher-rate taxpayer explained

Arun is a sole trader and had profits of £60,000. This is how his income tax for 2021/22 can be calculated:

0% on first £12,570 = £0

20% on next £37,700 = £7,540

40% on final £9,730 = £3,892

Total income tax bill = £11,432

Read our top 10 tax saving tips here.

Marriage Allowance

Marriage tax allowance allows you to transfer £1,260 of your personal allowance (this is the same amount you can earn tax-free each tax year) to your spouse or civil partner if they earn more than you. It is free to apply for Marriage Allowance. This can reduce your tax bill by £252 every tax year.

In order to benefit from this allowance as a couple, you need to earn less than your partner and have an income of less than £12,570. Your partner’s income has to range between £12,502 and £50,270 for you to be eligible.

You are able to backdate your claim to include any tax year since 5 April 2017 that you were eligible for Marriage Allowance.

In order to register for Marriage Allowance register at: www.gov.uk/marriageallowance

Different incomes and their tax levels

Income between £100,000 and £125,140

If your income exceeds the £100,00, your personal income tax allowance is gradually taken away from you. The more you earn, the less you get for your personal allowance. It is reduced by £1 for every £2 you earn above £100,000. This means that if your income exceeds £125,140 this year, you will have no personal allowance at all.

It is reduced by £1 every £2 you earn after £100,000.

If you are earning over £100,00 this tax will really take its toll on you.

Paying 60% tax

If you are earning a high income of £100,00 or more, the effect is that anyone earning this or higher will face a hefty marginal income tax rate of 60%.

Income over £150,000

Once your income rises above £150,000, you will have to start paying income tax at 45% on most types of your income. This is also known as the additional rate of tax.

You can find out more about how to reduce your tax here.

What income is taxed?

The above tax rates apply to most types on income including:

  • Salaries
  • Pensions
  • Self-employment profits
  • Rental profits
  • Sole traders and partnerships

Many types of income are also subject to national insurance, whereas some types of income are subject to different income tax rates.

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Many individuals receive dividends from stock market companies or from their own private companies. You may get dividend payments if you own shares in a company. You can earn some of your dividend income tax free each year.

You do not have to pay tax on any dividend income that falls within your personal allowance. This is the amount of income you earn per tax year that is tax free.

You do not have to pay tax on dividends from share in an ISA or any dividends received from a pension. You also get a dividend allowance each year.

You only pay tax on any dividend income above the dividend allowance.

For dividends that are taxable, the tax rates on those dividends are usually lower than other types of income. This is due to the fact that dividends are paid out after companies’ after-tax profits. This essentially means that dividend income is taxed twice.

Dividend tax credits have been abolished since 2016. Therefore, it is no longer necessary to gross up your dividends to calculate your tax. It is now a lot simpler, as all tax calculations now work with cash dividends.

Although that is great news, it also comes with some bad news: new tax rates for cash dividends have been introduced. These new rates are 7.5% higher than the previous ones. However, due to the ‘dividend allowance’, the first £2,000 dividend income you receive is completely tax free. Regardless of income, all taxpayers can benefit from this allowance.

For those receiving dividends, these following tax rates apply:

  • Basic-rate taxpayers: 7.5%
  • Higher-rate taxpayers: 32.5%
  • Additional-rate taxpayers: 38.1%

These rates will always be subject to the highest possible tax rate as dividends are always treated as the top slice of your income.

Click here to read our blog on 10 tax saving tips for vets.

How dividend allowance works

The dividend allowance is available for anyone (regardless of income) who has dividend income. The dividend allowance means that you will not have to pay tax on the first £5,000 of the dividend income. The dividend allowance is not given as an additional standalone tax-free amount of £2,000. 

Instead, it usually uses up some of your basic-rate band of higher-rate band. Dividends aren’t treated as sole income; they are treated as the top addition to your income and is, therefore, taxed at your highest marginal rate. The dividend allowance exempts the bottom £2,000 of that income from tax.

This means that if you have dividend income taxed at both x7.5% and 32.5%, the allowance will exempt some of the income taxed at 7.5%.

The recent changes in dividend tax rates includes an increase that was designed to extract more tax from those company owners who take most of their income as dividends. The main beneficiaries are higher-rate taxpayers and additional-rate taxpayers who receive relatively small amounts of income which is usually accumulated from stock market investments.

Changes in tax laws over the years has meant that if your investments were not stored and sheltered in a pension, an ISA or a capital trust you would have had to pay 25% or 30.6% tax on all dividend income. However, at present, you can receive £2,000 tax free.

Action Points

  • Review your dividend income to determine if it falls within the £2,000 dividend allowance for tax-free treatment.
  • Understand that the dividend allowance consumes part of your basic or higher-rate tax band, rather than acting as a separate tax-free amount.
  • Assess how your dividends are taxed, considering they are added on top of your other income and taxed at your highest marginal rate.
  • If applicable, identify portions of your dividend income that may be taxed at different rates (e.g., 7.5% and 32.5%) and apply the allowance to minimize tax liability.
  • Stay informed about recent changes in dividend tax rates, especially if you are a company owner who receives significant income through dividends.
  • Consider financial planning strategies such as investing in pensions, ISAs, or capital trusts to shelter dividend income from higher tax rates.

Income tax examples

Example 1:

In 2021/22 Brendan has a pension income of £49,270 and dividend income of £6,000.

The first £12,570 of his pension is covered by his personal allowance and the next £36,700 is taxed at 20%.

This leaves him with £1,000 of basic-rate band remaining.

£2,000 of his dividend income is tax free. The first £1,000 uses up what’s left of his basic-rate band (preventing him from paying 7.5% tax), leaving £1,000 of dividend allowance to use in the higher-rate band (preventing him from paying 32.5% tax).

The final £4,000 of dividend income is taxed at the 32.5% higher rate. 10

Example 2:

In 2021/22 Julia has £60,000 of rental income and £3,000 of dividend income. Her rental income uses up her personal allowance and basic-rate band and some of it is taxed at the 40% higher rate.

The first £2,000 of her dividend income is covered by the dividend allowance, leaving £1,000 subject to tax at the 32.5% higher rate.

The dividend allowance does not use up her basic-rate band because none of her dividends fall into the basic-rate band.

Example 3:

In 2021/22 Leon has a £130,000 salary and £50,000 dividend. With this much income his personal allowance is completely withdrawn.

The first £2,000 of his dividend income is covered by the dividend allowance, leaving £18,000 taxed at the 32.5% higher rate. Along with his salary this takes Leon up to the £150,000 additional rate threshold.

The final £30,000 of his dividend income is taxed at 38.1%.

Note, Leon has dividend income taxed at both the higher rate and additional rate. The dividend allowance reduces the amount of his dividend income taxed at the 32.5% higher rate.

Example 4:

In 2021/22 Martin has a £100,000 salary, £50,000 of rental income and £50,000 of dividend income. With this much income his personal allowance is completely withdrawn.

His salary and rental income take him up to the £150,000 additional rate threshold. The first £2,000 of his dividend income is covered by the dividend allowance, leaving £48,000 taxed at the 38.1% additional rate. The dividend allowance reduces the amount of his dividend income taxed at the additional rate.

UK tax on foreign dividends

Buying into shares worldwide is very common these days, particularly within US companies. This impacts your dividend income as these foreign dividends are often subject to withholding tax.

Usually, the overseas company will deduct tax before actually paying you the dividend. It also works in your favour that the UK has double tax treaties with many countries overseas that reduces the amount of payable foreign tax, this is usually between 10% and 15%.

The dividend withholding tax rate in the US is normally 30% but due to the double tax agreement between the UK and US, the amount of withholding tax can now be reduced to 15%. This can be done by completing form W-8BEN, issued by the US Internal Revenue Service (IRS). In many cases, mostly with online investment, stockbrokers will handle these forms for you on your behalf to ensure a smooth process for you.

This double tax agreement also provides a specific exemption for pension schemes. This means that US dividends can be received tax-free if the shares are held inside a pension scheme. If your overseas shares are held outside a pension scheme (e.g., SIPP) or an ISA, your income from your overseas dividends will be subject to UK income tax. The double tax agreement does not recognise ISAs. ISA investors will still be subject to the 15% withholding tax.

You may be able to claim Foreign Tax Credit Relief when you submit your tax return. This allows the overseas tax paid to be deducted from the owed amount of UK tax. However, the amount deducted cannot exceed the UK tax payable on the income.

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Interest Income

Personal Savings Allowance

Your Personal Savings Allowance is provided at a 0% tax rate for up to £1,000 of your interest income if you are a basic-rate taxpayer and up to £500 if you are a higher-rate taxpayer. The more you earn, the more your personal saving allowance decreases. Additional rate taxpayers do not receive this allowance.

The amount of income that falls within your savings allowance will still count towards your basic-rate or higher-rate limit and can, therefore, affect the level of savings allowance you are entitled to and the rate of tax payable on any savings income you receive in excess of this allowance.

The starting rate band

There is a 0% starting rate for up to £5,000 of interest income. However, in most cases only those who are on low incomes can use it. You are only able to benefit from this 0% starting rate this tax year if your non-savings income is less than £17,570 (this is £12,570 personal allowance + £5,000 starting rate band). Normally, your non-savings income will include your salary and pensions, but it does not include your dividends.

Many of you reading this probably won’t be able to use the 0% starting rate this is due to you having more than £17,570 of non-savings income. However, there may be another option for you. If you are unable to benefit from starting rate band, you may be able to benefit from the Personal Saving Allowance.

Future income tax changes

Rishi Sunak has promised that after the devasting affects of the pandemic, our government is not going to raise the rates of income tax, national insurance, or VAT. This means that most income tax thresholds and allowances will be frozen until 5th April 2026. This includes:

–          Personal allowance £12,570

–          Income tax higher rate 

Further Information on Accounts & Tax

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Book a free, no-obligation consultation with one of the team to find out how we can make your accounts & tax easier, quicker and cheaper.

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