How does UK income tax work?

We are specifically looking at England, Wales and N. Ireland here as taxes in Scotland differ ever-so slightly.

UK Income Tax Rates

In the UK, we pay income tax on earned income from employment, self-employment, rental income, interest income and similar.

Tax on this income is calculated using “tax bands” which are split into three separate income ranges:

“Basic Rate Tax Band” - income from £12,571 to £50,270 per tax year (20%)

“Higher Rate Tax Band” - income from £50,271 to £125,140 per tax year (40%)

“Additional Rate Tax Band” - income from £125,141+ per tax year (45%)

What is the Personal Allowance?

You may have noticed that the first band here starts at income of £12,571 and this is because everyone starts with a “Personal Allowance” of £12,570 which is taxed at 0% (tax-free). Therefore, if your income was under this amount for a tax year you would not pay income tax.

It is important to note that once your income exceeds £100,000 in a tax year, you start to lose this allowance at a rate of £1 per £2 earned. As an example, if you earned £105,000 you would lose £2,500 of the personal allowance and only have £10,070 remaining. If your income reaches the additional rate threshold of £125,141 you will pay tax on all of your income in the year (more often than not).

UK Income Tax Example

There is a common misconception in the UK that once your income falls into the next “band” that your entire income gets taxed at this new rate, but it is really important to understand that this is not the case. Instead, your income gets segmented into the different tax bands and taxed at the appropriate rate, here is an example:

Earnings of £75,000

  • First £12,570 taxed at 0% = £0

  • Second £37,700 taxed at 20% = £7,540

  • Third £24,730 taxed at 40% = £9,892

Therefore, income tax is actually £17,432 which works out at an equivalent tax rate of 23.24% of income. Another example, looking at losing the personal allowance shows how valuable this benefit is:

Earnings of £150,000

  • First £0 taxed at 0% (personal allowance lost as income > £125,140)

  • Second £37,700 taxed at 20% = £7,540

  • Third £87,440 taxed at 40% = £34,976

  • Fourth £24,860 taxed at 45% = £11,187

Therefore, income tax is actually £53,703 which works out at an equivalent tax rate of 35.8% of income. The reason why this gets so expensive is because of the loss of that personal allowance which is often referred to as reaching the “60% tax trap”.

What is the 60% tax trap?

In the second example above you will have noticed how the income that would normally have been taxed at 0% (the personal allowance) has actually been added to the “higher rate” tax band meaning that the £12,570 was taxed at 40%. As a result of how the rules work, any income earned between £100,000 and £125,140 is effectively taxed at 60% - here’s how:

  • The income falls into the higher rate tax band (£50,271 to £125,140) so gets taxed at 40%

  • As every £2 reduces your personal allowance by £1, this gets booted into the 40% rate so each £1 gets taxed at 20% (£2 at 40%)

  • As a result every £1 earned is taxed at 60%

How to avoid the 60% tax trap

You can reduce your “adjusted net income” to below £100,000 to avoid this income being taxed at 60% within the “trap” but it is not always the best option for those who rely on their cash and need it now, these are the best ways to avoid the tax trap:

  • Contribute excess income into a pension pot

  • Contribute excess income towards charitable donations

These methods can be technical and need to take into account a number of factors, and should be discussed with your accountant and or financial advisor.