Personal Finance 2: basic income tax

by George Hatjoullis

It never ceases to amaze me how many people do not understand how the tax they pay on income is calculated. Some basic understanding is essential in order to grasp the significance of some financial products so a quick introduction to income tax basics is introduced here. The exercise will assume an average wage of £26500 p.a. and the 2013/2014 tax rates.

Our average earner gets a personal income tax allowance of £9,440 p.a in 2013/14. This means she can earn up to this amount free of income tax. However, for every pound above this level she must pay 20p to the tax man. Note she does not pay 20p for every pound she earns, as the £9,440 is still free of tax. For average earnings of £26500 the tax bill is [£26,500-£9,440]x0.2=£3,412. Unfortunately, this is just the tax. There is also national insurance to consider. To make things messy the NI bands and limits are expressed as weekly amounts whilst tax is always in annual amounts. Employees normally pay class 1 NI contributions of 12% on income over £149 p.w. but only up to £797 p.w. The average wage on a 52 week year is £509.62 so the average earner pays [£509.62-£149]x0.12×52= £2250.24 p.a. in NICs. Take-home pay is thus £26,500-£3,412-£2,250.24=£20,837.76.

One common misconception is that once one enters a higher tax bracket all income is taxed at the higher rate. This is not so. Only the amounts above the thresholds are taxed at the higher rates. In order to be taxed at the marginal rate of 40% one needs a total income £41,450 per annum. The tax free personal allowance is £9,440 and income above this level is taxed at 20% up to an additional £32,010. Only income above this level is taxed at 40%. It is interesting to note that a married couple both earning £26,500 each are much better off than one earning £53,000 and the other not working (ignoring other benefits and allowances).  The tax and NIC bill for both working is £11,324.48, leaving a joint take-home pay of £41,675.52. The tax and NIC bill for one person earning £53,000 p.a. is £15,297, leaving an annual take-home pay of only £37,703 per annum. The difference is ££3,972.52. Sharing childcare and allowing both careers to develop makes economic sense in a progressive tax system.

The reason the single income is penalised is because some income is moved into a higher tax bracket. Many financial activities are dedicated to removing income from the taxable category and keeping taxable income in the lowest possible tax band. This is not simply a matter for very rich people looking for tax avoidance schemes. This can be quite legitimately achieved through personal child care and career plans (as above) and through full use of government sponsored tax efficient savings vehicles such as Individual Savings Accounts (ISA) and pension plans or by being aware of the tax benefits of owning a home over renting. This said, it cannot be emphasised too strongly that one should never enter an investment arrangement purely for the tax benefits. The investment should first make sense and then be implemented in the most tax efficient manner consistent with tax law.