What is Income Tax? How to Set Up a Personal Tax Account?

Income tax is a crucial component of the UK’s taxation system, providing a significant portion of the UK government's revenue used to fund public services such as healthcare, education, and infrastructure. It is a tax charged on an individual's total income, including earnings from employment, business profits, investment income, and other sources. Understanding how income tax works in the UK is essential for both residents and businesses to ensure compliance and effective financial planning. This article offers a detailed overview of income tax, covering its fundamentals, tax brackets, allowances, and filing procedures.

One useful tool for this is a Personal Tax Account, which helps you handle your tax affairs easily and efficiently. By setting up a personal tax account, you can easily manage your tax affairs, access tax-related services, and stay updated on your tax obligations. Let's dive into the world of income tax and discover how to set up a personal tax account to streamline your tax matters.

Income tax is a tax levied directly on personal income. In the UK, it is managed by HMRC, the government agency responsible for collecting taxes. Income tax applies to various forms of income, including:

• Earnings from employment
• Profits from self-employment
• Pension income
• Rental income
• Interest on savings income
• Dividends from shares
• Certain state benefits

Non-Taxable Income

Not all income is subject to tax. Some non-taxable incomes include:

• Certain state benefits (e.g., Housing Benefit, Child Benefit, Disability Living Allowance)
• Premium Bond and National Lottery winnings
• Some scholarships and grants
• Income from Individual Savings Accounts (ISAs)

How Income Tax Works?

Income tax is a tax charged on an individual's total income during a specific tax year. The tax year is usually a 12-month period determined by the government for tax purposes. The amount of income subject to tax is known as taxable income, which is determined by subtracting allowable deductions and allowances from the total income.

Income tax is important as it provides governments with revenue to fund public services such as healthcare, education, infrastructure, and social welfare programs. It ensures that individuals contribute their fair share towards the functioning of society. The tax rates for income tax are progressive, meaning that higher income earners pay a higher percentage of their income in tax.

Knowing how income tax works is crucial for managing your money effectively. By understanding the tax system, you can plan your finances better, ensure you are paying the correct amount of tax, and take advantage of any income tax reliefs or allowances you may be entitled to. This can help you save money and avoid unexpected tax bills.

Income tax rates and tax brackets determine the percentage of income that individuals are required to pay in tax. The tax system is progressive, meaning that higher-income individuals pay a higher percentage of their income in tax. The current tax bands and rates are:

Your income is taxed progressively, meaning you only pay the higher rate on the part of your income that falls within each band. For example, if you earn £60,000, you pay 20% on the income between £12,571 and £50,270, and 40% on the income over £50,270.

Personal Allowance

Allowances can reduce the amount of income that is subject to tax. The personal allowance is the amount of income you can earn each year without paying tax. It is deducted from the total income to calculate the taxable income. The personal allowance for 2024/25 is £12,570.

Tax-Free Allowances and Reliefs

In addition to the personal allowance, there are other tax-free allowances and reliefs that can reduce your taxable income:

• Marriage Allowance: Allows you to transfer 10% of your personal allowance to your spouse or civil partner if they earn more than you.
• Blind Person’s Allowance: An additional allowance for those who are registered blind.
• Dividend Allowance: The first £500 of dividend income is tax-free.
• Personal Savings Allowance: Basic rate taxpayers can earn up to £1,000 in savings interest tax-free, and higher rate taxpayers can earn up to £500.

National Insurance Contributions (NICs)

National Insurance Contributions (NICs) are another type of tax that supports state benefits like the NHS, state pensions, and unemployment benefits. NICs are similar to income tax but are specifically reserved for these services.

There are different classes of NICs, each with its own rate:

Class 1: Paid by employees and employers on earnings

Class 2: Paid by self-employed people at a flat rate

Class 3: Voluntary contributions to fill gaps in your NIC record

Class 4: Paid by self-employed people on profits

PAYE System

The Pay As You Earn (PAYE) system is how most employees pay their income tax and NICs. Under PAYE, the employer deducts tax and NICs from employee's wages before paying. This system ensures that the tax is paid regularly and accurately throughout the year.

Employers use employees' tax code, provided by HMRC, to determine how much tax to deduct. The tax code reflects personal allowance and any other adjustments needed. At the end of the tax year, employee receives a P60 form summarizing the total pay and deductions, which helps ensure everything is correct and allows employees to claim any tax refunds if they've overpaid.

Calculating income tax can seem complex, but breaking it down into simple steps makes it easier to understand.

Step 1: Identify Total Income

First, determine your total income for the current tax year (April 6th to April 5th). Your total income includes:

• Earnings from Employment: Your salary, wages, bonuses, and any other benefits.
• Self-Employment Income: Profits from your own business or freelance work.
• Pension Income: Money received from state, company, or personal pensions.
• Rental Income: Earnings from letting out property.
• Interest on Savings: Interest earned from bank accounts and savings.
• Dividends: Earnings from shares and investments.

Step 2: Deduct Allowances

Next, deduct your personal allowance from your total income. The personal allowance is the amount of income you can earn each year tax-free. For the tax year 2024/25, the standard personal allowance is £12,570.

If your income exceeds £100,000, your personal allowance decreases by £1 for every £2 you earn over this threshold.

Step 3: Apply the Tax Rates

The UK uses a progressive tax system with different rates for different income bands. After deducting your personal allowance, apply the rates of income tax to your remaining income.

Step 4: Calculate Tax

Calculate the tax for each income band separately:

Basic Rate Calculation:

Subtract your personal allowance from your total income.

Calculate 20% of the amount between £12,571 and £50,270.

Higher Rate Calculation:

If your income is above £50,270, calculate 40% of the amount between £50,271 and £125,140.

Additional Rate Calculation:

If your income exceeds £125,140, calculate 45% of the amount over £125,140.

Step 5: Add Up the Tax Amounts

Add the tax amounts from each band to get your total income tax liability for the year.

Example Calculation

Let's say your total income for the year is £60,000.

Total Income: £60,000

Tax Allowance: £12,570

Taxable Income: £60,000 - £12,570 = £47,430

Now, apply the tax rates:

Basic Rate (20%):

Income from £12,571 to £50,270: £50,270 - £12,570 = £37,700

Tax: £37,700 x 20% = £7,540

Higher Rate (40%):

Income from £50,271 to £60,000: £60,000 - £50,270 = £9,730

Tax: £9,730 x 40% = £3,892

Total Tax: £7,540 (basic rate) + £3,892 (higher rate) = £11,432

Tax Planning Strategies

Tax planning involves utilizing legal strategies to minimize the amount of tax you owe. By taking advantage of available deductions and credits, you can potentially reduce your taxable income and lower your overall tax bill.

1. Maximizing Deductions and Credits

One effective tax planning strategy is maximizing deductions and credits. Tax credits are a dollar-for-dollar reduction in your tax liability, while deductions reduce your taxable income. Some common tax credits include the Child Tax Credit, which provides a credit for each qualifying child, and the Earned Income Tax Credit, which is available to low-income individuals and families.

2. Make Use of Personal Allowances

For the 2024/25 tax year, the personal allowance is £12,570. To make the most of this, ensure you are not missing out on any allowances you are entitled to. Additionally, married couples may benefit from the Married Couple’s Allowance, which allows one spouse to transfer unused personal allowances to the other spouse, reducing their overall tax bill.

3. Maximize ISA Contributions

Individual Savings Accounts (ISAs) allow your savings to grow tax-free. You can invest up to £20,000 per tax year into ISAs. Consider utilizing different types of ISAs like Cash ISAs, Stocks and Shares ISAs, and Innovative Finance ISAs to shield more of your income from tax.

4. Contribute to a Pension

Pension contributions are a tax-efficient way to save for retirement. The government adds a tax relief of up to 45% on contributions, depending on your income tax band. For the 2024/25 tax year, the annual allowance for pension contributions is £60,000, but this may be lower if you are a high earner.

5. Use Capital Gains Tax Allowance

You have an annual capital gains tax (CGT) allowance, which is the amount of profit you can make on the sale of assets before paying tax. For the 2024/25 tax year, the CGT allowance is £3,000. To optimize this, consider spreading the sale of assets over several years to use the annual allowance each year.

6. Claim Business Expenses

If you are self-employed or run a business, claiming allowable expenses can significantly reduce your tax bill. These expenses include costs for office supplies, travel, and even a portion of your home utility bills if you work from home. Keep detailed records and receipts to support your claims.

7. Utilize Gift Allowances

Gifting assets can be an effective way to reduce inheritance tax liabilities. Each tax year, you can gift up to £3,000 without it being added to the value of your estate. Additionally, small gifts up to £250 per person per year and regular gifts out of income can be exempt from inheritance tax.

8. Make Charitable Donations

Donating to charities can reduce your tax bill through Gift Aid. When you make a donation, the charity can reclaim the basic rate of tax on your gift, and higher-rate taxpayers can claim the difference between the higher rate and the basic rate on their tax return.

10. Seek Professional Advice

Self employed Tax brackets and allowances change regularly. Staying informed about these changes is crucial for effective tax planning. Consulting with a tax accountant benefits you with the personalized tax services to manage complex tax rules and makes the most of available tax-saving strategies.

Income Tax Mistakes to Avoid

When it comes to income tax, there are several common mistakes that individuals should avoid to prevent potential penalties or interest charges.

• Missing the Filing Deadline: One of the most common mistakes is missing the filing deadline. In the UK, the deadline for submitting a self-assessment tax return online is 31st January following the end of the tax year.
• Incorrectly Claiming Deductions and Credits: Claiming deductions or credits you’re not entitled to, or missing out on ones you are eligible for, can significantly impact your tax bill.
• Not Keeping Adequate Records: Good record-keeping is essential for accurate tax reporting. Keep all receipts, invoices, bank statements, and other financial documents for at least six years. This helps in case of audits and ensures you can substantiate your claims.
• Tax Calculation Errors: Simple math errors can lead to incorrect tax calculations. Using accounting software like Freeagent or hiring a personal tax accountant can help avoid these mistakes.
• Ignoring Tax Notices: If you receive a notice from HMRC, don’t ignore it. Respond promptly and address any issues raised. Ignoring tax notices can lead to further penalties and complications.

A personal tax account is an online service provided by HMRC in the UK. By using a personal tax account, you can easily view and update your tax information, check your tax code, submit tax returns, and make payments.

Benefits of Having a Personal Tax Account

1. A PTA allows you to view and update all your tax information such as tax code, address, marital status, etc. in one place.
2. Track your employment income and tax deductions in real-time
3. You can file your Self-Assessment tax returns online through your PTA.
4. The PTA provides reminders and notifications about important tax deadlines, helping you avoid late filing penalties.
5. View real-time calculations of your tax liabilities based on the information HMRC holds.
6. You can apply for various tax reliefs and allowances.
7. The PTA is a secure platform, protecting your personal and financial information. You can access it anytime, anywhere, with an internet connection.
8. You can make tax payments directly through your PTA, ensuring your payments are processed promptly and securely.
9. If you have overpaid tax, you can claim a refund through your PTA.
10. You can communicate directly with HMRC through your PTA, using the secure messaging service.

Documents Required to Create a Personal Tax Account:

National Insurance number or UK postcode and up to 2 of the following:

• a valid UK passport or non-UK passport with a biometric chip
• a UK photocard driving licence issued by the DVLA (or DVA in Northern Ireland)
• a UK biometric residence permit or card
• a payslip from the last 3 months or a P60 from your employer for the last tax year
• details of a tax credit claim
• details from a Self Assessment tax return
• information held on your credit record (such as loans, credit cards or mortgages)

1. Go to the personal tax account page on HMRC’s official website and click the green button labeled ‘Start now’.
2. You’ll be prompted to sign in with your Government Gateway account using your Government Gateway user ID and password. If you don’t have a Government Gateway account, click ‘Create sign in details’ under the ‘New users of Government Gateway’ heading.
3. Enter your email address. You’ll receive a verification code via email. Enter this code on the website and click ‘Continue’.
4. Provide your full name and set a strong password (at least 10 characters).
5. Get your Government Gateway user ID, a 12-digit number. Use this ID to sign into Government Gateway along with the password you just set.
6. Select the type of personal tax account you want to create. You have three options:
   • Individual: For personal tax accounts, tax credits, self assessment, and child benefit
   • Organisation: For limited companies, partnerships, trusts, charities, and estates
   • Tax Agent: For bookkeepers and accountants acting on behalf of clients
7. If you’re creating a personal tax account for yourself, select ‘Individual’ and click ‘Continue’.
8. Set up extra security measures to ensure only you can sign in. This includes providing your phone number and choosing how you want to receive access codes.
9. Enter personal identification information such as your National Insurance number, birth date, and other details about your income and employment status. Follow the on-screen prompts to complete this process.
10. Once you've completed these steps, you’re ready to use your personal tax account. You can now manage your tax affairs online easily and securely.

Understanding income tax and setting up a personal tax account is crucial for managing your finances effectively. Knowing how income tax works helps you plan better, avoid unexpected bills, and make the most of tax reliefs and allowances. A personal tax account makes managing your taxes easier, allowing you to check your tax codes, submit returns, and make payments all in one place.

Take proactive steps to manage your personal taxes. Set up your personal tax account today, keep your information up to date, and regularly check your account. This will help you stay on top of your tax obligations and avoid any surprises. Additionally, we advise hiring a personal tax accountant to ensure your tax returns are accurate and to help you identify potential savings. Stay proactive, informed, and in control of your taxes for a secure financial future.