Hi all,
I thought I'd put to rest all of these tax threads and try to cover the basics to educate and help people realise how that deduction on your payslip is calculated. Feel free to ask questions, but please note the disclaimer below...
DISCLAIMER
The tax advice contained throughout this thread is not advice specific to you. It is general tax knowledge that you could find elsewhere on the web. Any answers given to questions are not to be acted upon without first checking with a local, qualified accountant or tax advisor. While people like myself, Vonhelmet and Pudney all work in tax and have certain tax qualifications, we are not your tax advisors.
Employment income
"Gross" in this thread means the amount in your contract.
"Net" means the cash you receive after tax and other relevant deductions such as pension contributions and salary sacrifice schemes.
When calculating your tax liability each tax year (6th April to 5th April) we look at your gross income. It includes dividends, interest, rental income, everything. For now, lets concentrate on your employment income.
Employment income is your gross employment earnings (on your P60) plus any benefits you receive (on your P11D) such as interest free loans, company cars, etc. Usually these benefits have a taxable equivalent of the cost to the company but things like company cars have it based on specific legislation such CO2 emissions and the car price. Please note: pension contributions made by your employer are not taxable.
Pension contributions made by yourself to an employer scheme is deducted from your employment income. Pension contributions made by yourself to a private scheme is accounted for in another way, detailed later.
How tax is calculated
Here are some examples of income. It is categorised between three categories, non-savings (taxed 1st), savings (2nd) and dividend income (3rd).
Savings are generally interest. You usually receive interest net of tax. Therefore the net is grossed up at (100/80) to generate the gross amount.
Dividends are received net of a notional 10% tax credit. Therefore the dividend is gross up at (100/90). The 10% gross up is then deducted with PAYE tax paid when calculating tax due. I.e. tax on dividends up to your HRB is tax free.
You receive a tax free person allowance of £7,475 (http://www.hmrc.gov.uk/rates/it.htm). This is deducted from your income in the order above so most people use it all up against their non-savings income.
Next you have income rate bands. Generally speaking, these are:
The income in each band is taxed at the following rates:
Finally, you have the tax liability. Now deduct the tax paid via PAYE (on your P60 or sum of your payslips), any dividends credits or taxed paid at source (e.g. on interest) or via payments on account. This will give your tax due.
Useful tip: If you only have employment income, use http://listentotaxman.com/ It will tell you exactly how much tax you should pay. Be warned, you need to know your your total employment income including the taxable value of your benefits such as company cars.
Private pension contributions
Private pension contributions extend your basic rate tax band. It does this by grossing up your pension contribution at the basic rate (100/80) to calculate the gross contribution and then extends the basic rate band by the gross calculated amount.
How tax is paid
Employment income: Tax is withheld via the PAYE (Pay As You Earn) scheme based on the tax code HMRC allocate to you at the start of the tax year. Your tax code splits your personal allowance and rate bands on a per month basis. Most people will have the tax code 747L.
Your tax code will be different if you have benefits or have untaxed earnings such as interest. This untaxed income is deducted from your personal allowance to give the new code. The aim is to make it so that you have no liability due at the end of the year. I recommend calculating the tax due from everything except dividend income and compare it to the tax deducted from your payslip each month.
Issues with tax codes
1. Your employer doesn't receive a tax code and puts you on BR (Emergency code). BR stands for Basic rate. This means they deduct tax at a flat rate of 20%. Unless this if your second job and you are not a higher rate tax payer, you're under or over paying. Call HMRC and get your tax code changed! (http://www.hmrc.gov.uk/incometax/emergency-code.htm)
2. I have a K code. HMRC believe your untaxed income is greater than your taxable income. See here for more info
Being a sole trader
This is non-saving income. It is calculated by taking your earnings and deducting certain allowable expenses. In order to be deductible the expense must be 'wholly and exclusively' for the purposes of the trade. Check with an accountant to find out if the expense is deductible. Don't forget capital allowances and remember, capital items (usually items with a life time of > 1 or 2 years) are not deductible!
National Insurance
Note: I will only talk about contributions you pay.
Employees pay Primary Class 1 on 'Readily convertible assets' aka cash or anything that goes through your payslip. Benefits or non RCA (on your P11D) do not suffer employee contributions.
Unlike income tax, national insurance is calculated based on income for the period you are paid (e.g. weekly or monthly) rather than on an annual basis. No national insurance is paid up to the Primary threshold for that period (£139 for a week). Between the PT and the Upper Earnings Limit (£817 for a week) suffers 12%. Anything above this is 1%.
Self employed people pay voluntary class 2 (£2.40 a week) and class 4 at 8% above the PT on an annual basis.
You currently need 30 years of National Insurance contributions to receive the full state pension. The information above assumes you haven't contracted out.
Contractors
WARNING: Do you really think HMRC would allow you to pay an effective rate of tax of 5% by simply becoming 'self employed' and being a contractor? IR35 affects a lot of people in these situations. Do not believe companies who claim they can get you 99% take home pay!!
IR35 basically forces you to pay tax as if you were employed by the company by calculating a deemed employment income. It is very complicated tax legislation but you generally fall within it if when you take out the middle party, you are an employee. Try this tool: http://www.hmrc.gov.uk/calcs/esi.htm
If you are classed as an employee, get immediate advice from a tax advisor or accountant. That tool isn't legally binding. HMRC can decide you're an employee anyway. Be warned!!
Partnerships
Partnerships are taxed in the same way as sole traders. Profit sharing, asset revaluations and adjustments to the partnership are all items that make partnerships slightly complicated. For this reason I'll simply advise you talk to an accountant.
This thread will be updated as common questions appear.
I thought I'd put to rest all of these tax threads and try to cover the basics to educate and help people realise how that deduction on your payslip is calculated. Feel free to ask questions, but please note the disclaimer below...
DISCLAIMER
The tax advice contained throughout this thread is not advice specific to you. It is general tax knowledge that you could find elsewhere on the web. Any answers given to questions are not to be acted upon without first checking with a local, qualified accountant or tax advisor. While people like myself, Vonhelmet and Pudney all work in tax and have certain tax qualifications, we are not your tax advisors.
Employment income
"Gross" in this thread means the amount in your contract.
"Net" means the cash you receive after tax and other relevant deductions such as pension contributions and salary sacrifice schemes.
When calculating your tax liability each tax year (6th April to 5th April) we look at your gross income. It includes dividends, interest, rental income, everything. For now, lets concentrate on your employment income.
Employment income is your gross employment earnings (on your P60) plus any benefits you receive (on your P11D) such as interest free loans, company cars, etc. Usually these benefits have a taxable equivalent of the cost to the company but things like company cars have it based on specific legislation such CO2 emissions and the car price. Please note: pension contributions made by your employer are not taxable.
Pension contributions made by yourself to an employer scheme is deducted from your employment income. Pension contributions made by yourself to a private scheme is accounted for in another way, detailed later.
How tax is calculated
Here are some examples of income. It is categorised between three categories, non-savings (taxed 1st), savings (2nd) and dividend income (3rd).
Savings are generally interest. You usually receive interest net of tax. Therefore the net is grossed up at (100/80) to generate the gross amount.
Dividends are received net of a notional 10% tax credit. Therefore the dividend is gross up at (100/90). The 10% gross up is then deducted with PAYE tax paid when calculating tax due. I.e. tax on dividends up to your HRB is tax free.
You receive a tax free person allowance of £7,475 (http://www.hmrc.gov.uk/rates/it.htm). This is deducted from your income in the order above so most people use it all up against their non-savings income.
Next you have income rate bands. Generally speaking, these are:
- Basic rate band (BRB) up to £35,000
- Higher rate (HRB) is £35,001 to £150,000
- Additional rate (ARB) is over £150,000
The income in each band is taxed at the following rates:
Finally, you have the tax liability. Now deduct the tax paid via PAYE (on your P60 or sum of your payslips), any dividends credits or taxed paid at source (e.g. on interest) or via payments on account. This will give your tax due.
Useful tip: If you only have employment income, use http://listentotaxman.com/ It will tell you exactly how much tax you should pay. Be warned, you need to know your your total employment income including the taxable value of your benefits such as company cars.
Private pension contributions
Private pension contributions extend your basic rate tax band. It does this by grossing up your pension contribution at the basic rate (100/80) to calculate the gross contribution and then extends the basic rate band by the gross calculated amount.
How tax is paid
Employment income: Tax is withheld via the PAYE (Pay As You Earn) scheme based on the tax code HMRC allocate to you at the start of the tax year. Your tax code splits your personal allowance and rate bands on a per month basis. Most people will have the tax code 747L.
Your tax code will be different if you have benefits or have untaxed earnings such as interest. This untaxed income is deducted from your personal allowance to give the new code. The aim is to make it so that you have no liability due at the end of the year. I recommend calculating the tax due from everything except dividend income and compare it to the tax deducted from your payslip each month.
Issues with tax codes
1. Your employer doesn't receive a tax code and puts you on BR (Emergency code). BR stands for Basic rate. This means they deduct tax at a flat rate of 20%. Unless this if your second job and you are not a higher rate tax payer, you're under or over paying. Call HMRC and get your tax code changed! (http://www.hmrc.gov.uk/incometax/emergency-code.htm)
2. I have a K code. HMRC believe your untaxed income is greater than your taxable income. See here for more info
Being a sole trader
This is non-saving income. It is calculated by taking your earnings and deducting certain allowable expenses. In order to be deductible the expense must be 'wholly and exclusively' for the purposes of the trade. Check with an accountant to find out if the expense is deductible. Don't forget capital allowances and remember, capital items (usually items with a life time of > 1 or 2 years) are not deductible!
National Insurance
Note: I will only talk about contributions you pay.
Employees pay Primary Class 1 on 'Readily convertible assets' aka cash or anything that goes through your payslip. Benefits or non RCA (on your P11D) do not suffer employee contributions.
Unlike income tax, national insurance is calculated based on income for the period you are paid (e.g. weekly or monthly) rather than on an annual basis. No national insurance is paid up to the Primary threshold for that period (£139 for a week). Between the PT and the Upper Earnings Limit (£817 for a week) suffers 12%. Anything above this is 1%.
Self employed people pay voluntary class 2 (£2.40 a week) and class 4 at 8% above the PT on an annual basis.
You currently need 30 years of National Insurance contributions to receive the full state pension. The information above assumes you haven't contracted out.
Contractors
WARNING: Do you really think HMRC would allow you to pay an effective rate of tax of 5% by simply becoming 'self employed' and being a contractor? IR35 affects a lot of people in these situations. Do not believe companies who claim they can get you 99% take home pay!!
IR35 basically forces you to pay tax as if you were employed by the company by calculating a deemed employment income. It is very complicated tax legislation but you generally fall within it if when you take out the middle party, you are an employee. Try this tool: http://www.hmrc.gov.uk/calcs/esi.htm
If you are classed as an employee, get immediate advice from a tax advisor or accountant. That tool isn't legally binding. HMRC can decide you're an employee anyway. Be warned!!
Partnerships
Partnerships are taxed in the same way as sole traders. Profit sharing, asset revaluations and adjustments to the partnership are all items that make partnerships slightly complicated. For this reason I'll simply advise you talk to an accountant.
This thread will be updated as common questions appear.
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