10.2 Income Tax

Question 1

What are the 3 categories an individual’s income can be separated into?

Answer 1

1. Non-savings income
2. Savings income
3. Dividend income

Question 2

What are the two main categories of non-savings income?

Answer 2

1. Income from employment, both employed and self-employed
2. Property income

Question 3

How do employees pay their income tax?

Answer 3

Employees have income tax deducted by the employers via the pay as you earn (PAYE). This means that employees will have paid all income tax due on their earnings automatically each tax year.

Note that employees may have savings and dividend income as well.

Question 4

How do the self-employed pay their income tax?

Answer 4

The self-employed have no income tax deducted by their customers and so are paid gross. They need to complete a tax return to tell the tax authorities how much tax they are due to pay. The self-employed pay their tax twice a year in January within the tax year to which it applies and in July after the tax year has ended. These are termed ‘payments on account’.

Question 5

What are the types of income from property?

Answer 5

• Income from commercial property (direct property investment)
• Incomes from a real estate investment trust (REITs) or property authorised investment funds (PAIFs) (indirect property investment)

It is also worth mentioning that distribution from real-estate investment trusts (REITs) are also classed as property income distributions (PIDs) and are taxed at this level.

Question 6

Explain savings income.

Answer 6

Most people can earn some income from bonds, bank accounts or annuities without a tax liability. Most of this income is now received gross, i.e. before any tax has been paid.

Question 7

Explain dividened income.

Answer 7

Individuals may receive income from their equity investments, in the form of dividends. These are also distributed gross.

Question 8

Explain statutory total income.

Answer 8

An individual may have a number of sources of income such as:

1. Non-savings income – this is taxed first
2. Savings income – this is taxed second
3. Dividend income – this is taxed third

Income from these sources is added together to find an individual’s statutory total income. Note that income is taxed in the order shown above, starting with non-savings income.

Question 9

What is the relationship between tax rates and sources of income?

Answer 9

Each source of income has its own rates of tax.

Question 10

What is the relationship between tax bands and statutory total income?

Answer 10

All sources of income use the same tax bands e.g. if an individual has statutory total income from any source above £37,700 they will be a higher rate taxpayer and pay higher rate tax on each £1 above this threshold.

Question 11

What is the usual tax rate for a higher rate tax payer?

Answer 11

A higher rate taxpayer will generally pay higher rate tax at 40% on each £1 above the higher rate threshold of £37,700, except for dividend income that has a different higher rate tax rate:

• Non-savings income – higher rate tax = 40%
• Savings income – higher rate tax = 40%
• Dividend income – higher rate tax = 32.5%

Question 12

Explain the additional rate of tax.

Answer 12

An additional rate of tax is for those earning more than £150,000. This rate is 45% for non-savings and savings income, and 38.1% for dividend income.

Question 13

How do donations to charity reduce total statutory income?

Answer 13

Donations to charities can be made tax-free by declaring these to HMRC. Where the donations are subject to gift aid, the charity can also claim back tax.

Question 14

What is the main rule around claiming tax relief on pension contributions?

Answer 14

Tax relief can be claimed on pension contributions, subject to a basic amount of £3,600 and a maximum amount of £40,000 per year. If these are unused, they can be carried forward for three years only.

Question 15

When is the £40,000 per year limit on pensions tapered?

Answer 15

The £40,000 per year limit on pensions is tapered for those with an adjusted income in excess of £240,000. Adjusted income is total income including that which is transferred to pensions, charities, etc.

For every £2 earned above £240,000, the annual limit will be reduced by £1. This will be subject to a minimum level of £4,000.

This means, should adjusted income be above £312,000, you will only get tax relief on £4,000 of pension contributions.

There is an exemption to this, where your adjusted income is above £240,000, but your net income (after charity donations and pension contributions, etc.) is less than £200,000.

Question 16

Summarise the income tax rates for financial year 2021-22

Answer 16

• A basic rate tax payer is anywhere between £0 to £37,700. For a basic rate tax payer non-savings income is taxed at 20%, the savings income above the tax-free amount is 20% and the dividend income above £2000 is taxed at 7.5%.
• A higher rate tax payer is anywhere between £37,701 to £150,000. For a higher rate tax payer non-savings income is taxed at 40%, the savings income above the tax-free amount is 40% and the dividend income above £2000 is taxed at 32.5%.
• An additional rate tax payer is above £150,000. For an additional rate tax payer non-savings income is taxed at 45%, the savings income above the tax-free amount is 45% and the dividend income above £2000 is taxed at 38.1%.

Question 17

List the different income tax rates.

Answer 17

Income tax rates on our non-savings income are different from the income tax rates on our savings income and on our dividend income.

Question 18

Give some examples of non-savings income.

Answer 18

• Money received – salary, overtime, bonuses, commission, profit share, etc.
• Benefits received – the monetary value of these benefits is called ‘benefits in kind’ e.g. company car, health insurance, preferential loans, etc.

Question 19

Which individuals are entitled to a new personal allowance each year?

Answer 19

UK, Isle of Man and Channel Islands residents and citizens of the EEA and Commonwealth are entitled to a new personal allowance each tax year.

Question 20

What is the personal allowance?

Answer 20

The personal allowance is an amount of income that can be earned tax-free each tax year.

Question 21

What happens once an individual’s income exceeds their personal allowance?

Answer 21

Every additional pound over the personal allowance starts incurring income tax.

Question 22

What do the first three digits of the personal allowance form?

Answer 22

An individual’s tax code

Question 23

When does the personal allowance start to reduce?

Answer 23

This personal allowance is, however, at risk for high income earners. Once an individual’s income reaches £100,000, the personal allowance begins to be taken away at a rate of £1 for every £2 earned above that figure. This means, for Financial Year 2021/22, anyone earning £125,140 or more has no personal allowance at all.

Question 24

Explain the marriage allowance.

Answer 24

The Marriage Allowance is available to those who are married or in a civil partnership. Where one partner earns less than £12,570 and the other pays tax at the basic rate (i.e. earns between £12,570 and £50,000), the lower earning partner is able to transfer £1,257 (10% of their personal allowance) to their higher earning partner.

Question 25

How is interest charged on savings income?

Answer 25

The first £5,000 of interest is taxed at 0%. However, this allowance is reduced by £1 for every £1 of non-savings income above the personal allowance (£12,570).

When combined non-savings and savings income is above £17,570 additional allowances apply.

Question 26

What are the tax free savings income bands?

Answer 26

• A basic rate taxpayer’s tax free savings income is £1000.
• A higher rate taxpayer’s tax free savings income is £500.
• An additional rate taxpayer does not have a tax free savings income.

Question 27

How is dividend income taxed?

Answer 27

There is no income tax on the first £2,000 of dividends. Anything above £2,000 is paid at the individual’s marginal rate.

Question 28

Which income is normally tax free?

Answer 28

Income that is paid into a pension or to a charity.

Question 29

If money is borrowed for certain activities the interest paid can be offset against income for that year. Which activities qualify for this?

Answer 29

1. Buying plant or machinery for employment use
2. Buying an interest in an unquoted employee-controlled company
3. Investing in a partnership
4. Investing in a co-operative
5. Buying ordinary shares in, or lending money to, a close company (a close company is one that is controlled by five or fewer shareholders or by its directors, regardless of their number)

Question 30

What are the rules surrounding interests on on buy-to-let mortgages and tax?

Answer 30

Interest paid on buy-to-let mortgages can no longer be offset against tax liabilities. Instead, landlords receive a tax credit of 20% on the mortgage interest paid.

Question 31

In the UK our non-savings income is potentially taxed at what four rates?

Answer 31

• 45%
• 40%
• 20%
• 0%.

Question 32

Denise, aged 25, has a part time job and earns £16,760 pa. What income tax will she pay?

Answer 32

Denise pays no tax on her first £12,570, as this is the tax free personal allowance. This leaves £4,190 of Denise’s income to be taxed at the 20% (basic rate) band meaning Denise will pay £838 in tax.

Question 33

Holly, aged 33, earns £75,670 pa. What income tax will she pay?

Answer 33

Holly’s total income is £75,670. She has a tax-free personal allowance of £12,570. Hence her taxable income is £63,100. Of the £63,100, £37,700 will be charged a basic rate of tax at 20% which is £7,540. £25,400 will be charged a higher rate of tax at 40% which is £10,160. £7,540 + £10,160 = £17,700. Hence Holly’s income tax is £17,700.

Question 34

What are the rules for taxation of property income?

Answer 34

• Income from property is looked at alongside non-savings income.
• Income from commercial property and real estate investment trusts (REITs) are taxed at either 45%, 40% or 20%.
• It is allowable to offset certain costs and expenses against property income, such as loan interest costs.

Question 35

How does taxation of trusts work?

Answer 35

Trusts are subject to income tax and the trustee is responsible for meeting the tax liabilities of the trust. These tax liabilities will be paid out of the trust assets. However, trusts are not taxed in the same way as individuals.

Question 36

What is the standard rate band?

Answer 36

For most trusts, the first £1,000 of income is taxed at the basic rate of tax: 20% for savings and property income and 7.5% for dividend income. This is called the standard rate band.

Question 37

What is the trust rate and dividend trust rate?

Answer 37

Any trust income above £1,000 is taxed at the additional rate: 45% for savings and property income and 38.1% for dividend income. This is referred to as the trust rate (dividend trust rate when referring to dividend income).

Question 38

What is the sequence of assessing trust income?

Answer 38

The sequence of assessing income is the same as for individuals: non-dividend income first and dividend income last.

Question 39

What is the trust’s £1,000 standard rate band based on?

Answer 39

The £1,000 standard rate band is based on the settlor, not the trust. If an individual sets up two trusts, the standard rate band is £500 for each trust.

Question 40

How does a beneficiary receive income from the trust?

Answer 40

Where a beneficiary receives income from the trust, they will receive that income net of the rate paid by the trust. As this is the additional rate of tax for any trust generating income above £1,000, there is the possibility that the beneficiary may need to reclaim tax from Her Majesty’s Revenue and Customs (HMRC).

Question 41

What are the tax rules for bare trusts?

Answer 41

Bare trust give absolute vested interest in the assets to the beneficiaries. For the taxation of these trusts, the trust is ignored. Instead the tax is paid at the beneficiary’s marginal rate of tax. This tax charge is liable on the trust asset, whether the income is paid out or not.