How income tax is calculated

Income tax is charged on most types of income but tax allowances protect some from the taxman.

Following the end of the tax year, which falls on 5 April each year, we look at the income tax rates and tax-free allowances.

What income tax will I pay?

Income tax is calculated on your earnings — employed or self-employed — in tiers. Essentially, the more you earn, the more tax you pay. It differs, however, depending on where in the country you live.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Income tax rates in England, Wales and Northern Ireland

Earnings are tax-free up to £12,570. This figure is known as the personal allowance.

After that you’ll pay what’s known as the basic rate of tax which is 20% on up to £50,270.

For earnings of £50,271 and £125,140 you’ll pay a higher rate of tax at 40%.

An additional rate of 45% is applied to earnings over £125,140.

Income tax rates in Scotland

If you live in Scotland the way that income tax is calculated is slightly different.

Everyone still has a £12,570 personal allowance. Then there are tiers. The starter rate of 19% is applied to earnings between £12,571 and £14,876.

What is the personal allowance?

The personal allowance – currently £12,570 – is the amount of earnings you can receive without paying any income tax at all.

When do you lose your personal allowance?

The personal allowance is handed to every working individual. However, when your earnings reach a certain level, you start to lose that allowance.

HM Revenue & Customs rules state that for every £2 you earn over £100,000 per annum, you lose £1 worth of your £12,570 tax-free personal allowance. Those who earn an income above £125,140 will have no personal allowance at all.

This rule effectively creates an income tax band of 60% for a portion of your earnings between £100,000 and £125,140.

As an example, let’s say an individual earns a salary of £100,000, and they receive a bonus of £20,000 giving a total of £120,000.

From this bonus, the higher rate of 40% is payable, which means that £8,000 would be deducted.

Since the bonus tips the numbers over the £100,000 threshold, there is the reduction to the personal allowance in this instance of £10,000, which also means there is an additional £10,000 brought into the higher rate income tax bracket.

This results in a further £4,000 of income tax being due, equivalent to a 60% tax rate.

Do dividends count towards the personal allowance?

Dividends are taxable — unless investments that generate dividends are held in an ISA — over and above an annual allowance. You don’t pay any tax on any dividend income that falls within your personal allowance and there’s also a separate annual dividend allowance of £500 per person.

So, if you received £13,070 in dividend income in the 2024/25 tax year, the first £12,570 could be covered by the personal allowance, and the remaining £500 by the dividend allowance.

Dividend tax over and above allowances (and outside an ISA) is charged at special rates according to the highest rate of income tax you pay.

The rate applied to dividend income for basic rate taxpayers is 8.75%. If the taxable dividend income tipped into the higher rate tax band, the rate of tax applied would be 33.75%, and for additional rate taxpayers, 39.35% tax rate would apply.

Does the personal allowance apply to capital gains?

The personal allowance does not apply to capital gains. Individuals have a separate annual capital gains tax exemption of £3,000 per person, per tax year.

If the total of all gains and losses in the tax year fall within this amount you don’t need to pay any tax.

Do savings count towards the personal allowance?

The amount of money held in savings does not directly impact your personal allowance for income tax. But you might have to pay income tax on interest received from savings.

The annual personal savings allowance (PSA) means basic rate taxpayers can earn £1,000 of tax-free interest every tax year, after which they pay 20%.

If you’re a higher rate taxpayer this allowance drops to £500 a year and after that your income from savings is taxed at 40%.

Top rate taxpayers don’t have a PSA so will pay 45% on interest from savings.

What is the marriage allowance?

The marriage allowance is a mechanism to allow married couples and those in civil partnerships to transfer 10% of your personal allowance to the other, who can then claim the value of that allowance.

This means £1,260 of your personal allowance can be transferred to your spouse or civil partner if they earn more than you. However, there are eligibility rules to apply.

Who can apply for the marriage allowance?

You must be married or in a civil partnership and one of you must be a non-taxpayer and one must be a basic-rate taxpayer. Higher or additional-rate taxpayers aren't eligible for this allowance.

The marriage allowance could reduce a tax bill by up to £252. It is also worth checking if you are eligible to backdate your claim, as in some cases you may be eligible to claim from tax years since 5th April 2020.

To be eligible for the marriage allowance in Scotland, your partner must pay the starter, basic or intermediate rate, which usually means their income is between £12,571 and £43,662.

How to transfer the personal allowance

The quickest way to apply for marriage allowance is online. You’ll need your National Insurance number and your partner’s National Insurance number.

There is also the option to apply by post, completing a MATCF form –– available on gov.uk.

You can also opt to do it through a self-assessment tax return if you’re already registered and file tax returns anyway.

Are income tax rates going up in 2025?

There are no planned changes to income tax rates in 2025. Usually, it would be expected that the income tax band thresholds would rise to reflect the increased cost of living, allowing workers to earn more money before higher tax rates kick in.

However, they have been frozen since 2021, and the personal tax-free allowance of £12,570 and other tax bands will be frozen up to and including the 2028/29 tax year.

Chancellor Rachel Reeves announced in her first Budget in October 2024 that thresholds will rise in line with inflation once again.

However, the policy of not increasing allowances in line with the cost of living forces millions of earners to pay more tax as wages go up.

It is known as a stealth tax because workers end up paying more tax as their salaries rise — without the government increasing headline tax rates.

Income tax if you’re self-employed

Do I need to fill in a self-assessment tax return?

If you’re self-employed you will need to file an annual self-assessment tax return which will calculate the amount of income tax you need to pay – unlike employed people who automatically pay tax through the PAYE (Pay As You Earn) system.

You can complete your own self-assessment tax return or enlist the help of an accountant to do it on your behalf. It’s important to have a keen understanding of what you will owe to ensure you keep enough back to cover the bill.

National Insurance

National Insurance is a tax on earnings paid by both employees and employers; the self-employed pay it on their profits. It’s used to pay for the NHS, benefits such as maternity pay, and the state pension.

The rates of NI are different for employed and self-employed people.

For those employed, you pay class 1 National Insurance contributions and the levels are tiered according to your earnings. No NI is due if you earn £0-£242 a week. You pay 8% on earnings between £242.01 and £967 and then 2% on those who earn over £967 a week.

The self-employed pay class 4 NI which is 6% on profits of £12,570 up to £50,270 and 2% on profits over £50,270.

Your NI contributions will be on your self-assessment tax return and are due at the same time as income tax.

You do not pay NI once you reach the state pension age. Though if you are self-employed you stop paying class 4 NI from the start of the tax year after the one in which you reach state pension age.