Income Tax Explained
Income tax is a tax charged on most types of income received by individuals in the UK. It is the government’s largest source of revenue and is administered by HMRC. The legal basis for income tax is found in the Income Tax Act 2007, the Income Tax (Earnings and Pensions) Act 2003, and the Income Tax (Trading and Other Income) Act 2005.
Income tax applies to earnings from employment, self-employment, pensions, rental income, savings interest, dividends, and most other forms of income.
How the rates and bands work
Income tax is charged at different rates depending on how much you earn. The rates apply to taxable income — your total income minus your personal allowance and any other deductions. In England, Wales and Northern Ireland there are three main rates above the personal allowance:
| Band | Rate |
|---|---|
| Personal Allowance | 0% |
| Basic rate | 20% |
| Higher rate | 40% |
| Additional rate | 45% |
The size of the personal allowance and the income levels where each band starts are set by Parliament, usually at the Budget, and they apply from 6 April for the whole tax year. Thresholds can be frozen for several years at a time, so check the current figures on GOV.UK rather than relying on an older table.
Personal Allowance Reduction
Most people get the standard personal allowance. However, it is reduced by £1 for every £2 of adjusted net income above £100,000, until it disappears completely.
This creates an effective marginal rate of 60% across the taper band — for every £100 earned in this band, you lose £50 of personal allowance (effectively taxed at 40%) plus pay 40% tax on the income itself.
Marriage Allowance
If your income is below the personal allowance, you can transfer 10% of the personal allowance to your spouse or civil partner, provided they are a basic rate taxpayer. Their tax bill falls by 20% of the amount transferred.
Blind Person’s Allowance
An additional allowance is available if you are registered blind, or severely sight impaired in Scotland and Northern Ireland. The amount rises each tax year and is published on GOV.UK.
How Income Is Taxed
Different types of income are taxed in a specific order, which affects the rates applied:
Non-Savings Income
This is the first layer and includes:
- Employment income (salary, wages, bonuses, benefits in kind)
- Self-employment profits
- Pension income
- Rental income
- Most other earned income
Non-savings income is taxed through PAYE for employees or through self-assessment for the self-employed and those with complex affairs.
Savings Income
Interest from bank accounts, building societies, bonds, and other savings is taxed after non-savings income.
Personal Savings Allowance — basic rate taxpayers can earn a set amount of savings interest tax-free each year. Higher rate taxpayers receive a smaller allowance, and additional rate taxpayers receive none. Some people with low earnings can also use the starting rate for savings.
Interest within an ISA is completely tax-free.
Dividend Income
Dividends are taxed last, after non-savings and savings income. The first slice is covered by the dividend allowance and taxed at 0%; the rest is taxed at the dividend ordinary, upper or additional rate depending on which band it falls into. Our dividend tax guide explains how this works.
Understanding dividend taxation is important for company directors who extract profits through a combination of salary and dividends rather than paying full salary subject to National Insurance.
Tax Codes
Your tax code tells your employer or pension provider how much tax-free income you are entitled to. The standard tax code is the personal allowance with the last digit removed, followed by the letter L. For example, a personal allowance of £12,570 gives the code 1257L.
HMRC adjusts tax codes to account for:
- Untaxed income from previous years
- Benefits in kind (company car, medical insurance)
- State Pension
- Reduced personal allowance due to high income
- Gift Aid contributions or pension relief
How Income Tax Is Collected
Through PAYE
Most employees and pensioners have income tax deducted at source through the PAYE system. The employer calculates tax based on the employee’s tax code and deducts it from each payment before the employee receives their net pay.
Through Self-Assessment
Self-employed individuals, landlords, and those with complex tax affairs report their income and calculate tax through self-assessment. This involves filing an annual tax return and paying any tax owed by 31 January following the end of the tax year.
Tax Deducted at Source
Some income has tax deducted before you receive it:
- Bank interest — since April 2016, paid gross (without tax deducted) for most individuals, with tax collected through PAYE code adjustments or self-assessment
- Construction industry payments — deducted under the Construction Industry Scheme
- Certain pension payments
Allowable Deductions
Certain payments reduce your taxable income:
Pension Contributions
Contributions to registered pension schemes receive tax relief:
- Basic rate relief is given at source (the pension provider claims it from HMRC)
- Higher and additional rate relief is claimed through self-assessment or PAYE code adjustment
- Contributions above the annual allowance (or 100% of earnings if lower) can trigger a tax charge; the allowance is set by Parliament and can be tapered for high earners
Gift Aid
Charitable donations through Gift Aid extend your basic rate band, providing relief at your marginal rate. The charity claims the basic rate tax (25% of the net donation) from HMRC, and higher/additional rate taxpayers claim the extra relief through self-assessment.
Employment Expenses
Employees can claim tax relief on certain expenses not reimbursed by their employer, such as:
- Professional subscriptions
- Tools and equipment for work
- Working from home allowance
- Uniform and work clothing
Income Tax and Other Taxes
Income tax is one of several taxes individuals may pay. It is distinct from:
- National Insurance contributions — a separate charge on earnings that funds state benefits
- Capital Gains Tax — charged on profits from selling assets
- VAT — a consumption tax on goods and services
- Corporation tax — paid by companies rather than individuals
Companies pay corporation tax on their profits rather than income tax. However, company directors pay income tax on any salary, bonuses, or dividends they receive from the company.
Scottish Income Tax
Scottish taxpayers pay Scottish Income Tax on their non-savings, non-dividend income. The Scottish Parliament sets its own rates and bands each year, with more bands than the rest of the UK: starter, basic, intermediate, higher, advanced and top rates. The personal allowance is the same across the UK. The Scottish Government publishes the current rates and bands.
Scottish taxpayers are identified by their S tax code prefix (for example, S1257L).
Record Keeping
Whether your tax is collected through PAYE or self-assessment, you should keep records of all income sources. The Companies Act 2006 and tax legislation require proper accounting records to be maintained. Self-employed individuals must keep records for at least 5 years after the filing deadline, and Making Tax Digital is progressively requiring these records to be digital.