Income tax

Published: February 5 2004 15:54 | Last updated: February 5 2004 15:54

Once your income goes over your allowances you start to pay income tax. There are five different rates of tax you might pay, depending on how much income you have and where it comes from.
You pay:

10 per cent on the first £1,920 of taxable income, whatever its source.
22 per cent on the next £27,980 if your income is from earnings or a pension, or 20 per cent if it is from savings.
40 per cent once your taxable income goes over £29,900.
Tax on dividends from share-based investments is set at 10 per cent on income below £29,900 and 32.5 per cent above that.

There is also national insurance, or NI, to pay. For 2002/03, this is fixed at 10 per cent of earnings between £4,615 and £30,420 a year. If you are self-employed, you’ll have a different NI payment structure. Employees over state pension age do not pay NI if they get an ‘exemption certificate’ from the Department of Social Security and give it to their employers.

How income is taxed

Working out the best way to organise your finances to pay the least possible income tax is not as easy as it should be. You need to know how income from different sources is taxed, whether tax is automatically deducted before you get the income, and when you can reclaim tax if you are a non-taxpayer.

Interest on bank and building society accounts is paid with 20 per cent tax already taken off. Non-taxpayers can get interest paid gross by filling in Inland Revenue form R85, available from bank branches. Anyone who has failed to do this in the last five years can reclaim the tax paid using form R40.
Interest on National Savings products varies. Some products offer tax-free returns (good for higher rate taxpayers), others are taxable but pay interest gross (good for non-taxpayers) or, like bank accounts, pay interest after 20 per cent tax.
Fixed interest investments such as government gilts and corporate bond funds may pay interest without tax deducted, but if not, any tax taken off can be reclaimed by non-taxpayers.
Insurance company products, such as guaranteed income bonds, with-profit bonds and endowments, pay out with basic rate tax (22 per cent) already deducted. Non-taxpayers cannot reclaim this tax.
Dividend income from share-based investments is paid with 10 per cent tax deducted. You can only reclaim this if your investments are held in a Pep or Isa (up to 2004). Non-taxpayers have been unable to reclaim tax on share dividends since April 1999.

How to cut your income tax bill

Make full use of your allowances. Couples where the partners are in different tax brackets can transfer income from the partner paying the most tax to the one paying less or none. You can do this by holding income-producing assets in the name of the non-or lower rate taxpayer, or if you run your own business, by paying him or her a salary. Any gift must be unconditional and any salary must be for a job actually performed.

Make use of children’s tax allowances if you can. Each child can earn interest of up to £200 a year (£100 per parent) from money given to them by their parents. They can earn income up to the full personal allowance on money given to them by anyone else, including grandparents.

Let out a room in your house. You can charge a lodger up to £80 a week and get the income tax-free under the rent a room scheme. If the rent you charge comes to more than the £4,250 a year allowed under the scheme, you can still deduct that allowance from the rent received and pay tax on the remainder.

Take out an Isa each year.You can put up to £7,000 into an Isa each tax year, sheltering your money from both income tax and capital gains tax.

Pay as much as you can afford into your pension. You get full tax relief on money paid into a pension scheme. With stakeholder pensions, introduced in April 2001, you can pay up to £3,600 a year into a pension on behalf of a child or non-working partner and get basic rate tax relief on the payments.

Invest for growth. Put money into investments that do not pay an income at all, such as the capital or zero dividend preference shares of split capital investment trusts.

Make use of your capital gains tax allowance. You can effectively provide yourself with tax-free money by taking investment profits up to the annual capital gains allowance each year to boost your income.

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Income tax