Frozen tax thresholds have increased the number of Brits paying income tax at the same time as squeezing the tax-free allowances that let people make an income without paying a penny to HMRC. But the tax system can still be made to work to your advantage, if you know how to play it.
An estimated 39.1 million people now pay income tax, according to HMRC data. This is an increase of 6.1 million from when income tax thresholds were frozen in the 2021/22 tax year, almost four years ago – an effect known as fiscal drag.
Basic rate taxpayers account for the vast majority, an estimated 30.4 million people, which is a rise of around 3 million since the freeze.
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Higher rate taxpayers are up by 2.65 million to 7.08 million, and additional rate taxpayers make up 1.23 million of the total, an increase of 710,000.
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Thanks to the state pension triple lock – which has seen the state pension increase every year since 2011 by inflation, average earnings or 2.5%, whichever is higher – 8.7m taxpayers are over state pension age, up 29% since the freeze.
Income tax thresholds will remain frozen until April 2031. Originally set to end in 2028, the freeze was extended by the government in the 2025 Autumn Budget to raise funds. Good news for the Treasury, not so good for personal incomes.
Yet there are still a few ways to legally generate an income free of tax, if you are willing to be flexible about where that income comes from.
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Between us, we’re paying billions more in tax than we did this time last year, and it’s only going to get worse, because those tax thresholds have been frozen until April 2031.
“It means the idea of generating a tax-free income has become even more attractive. Fortunately, there are a number of allowances and rules which mean you can take steps to protect yourself from a horrible tax bill.”
How to generate tax-free income every year
1. Keep up to £12,570
The personal allowance – the first £12,570 of taxable income per person per year – is tax-free. If you earn less than this, you won’t pay a penny of income tax.
The personal allowance is reduced by £1 for every £2 of taxable income above £100,000, which is why earnings between £100,000 and £125,140 are taxed at an effective 60% tax rate.
That’s one reason why people who make more than £100,000 may consider making additional pension contributions to cut their taxable income and so keep more of their personal allowance.
2. Rent a room to a lodger and keep up to £7,500
If you rent a furnished room in your home to a lodger, the first £7,500 of rent each year is tax-free under the rent-a-room scheme. This limit hasn’t risen for a decade, however, and if you go over it you’ll need to file a self-assessment tax return.
3. Rent out land or property for up to £1,000
This could be from a property business, but it doesn’t count for renting out a room in your own property that falls under the rent-a-room scheme.
4. Side hustle earnings are tax-free up to £1,000
If you make a modest income from a side hustle or hobby, such as selling items you have made on Ebay, Etsy or Vinted, you can keep what you make without paying income tax up to £1,000. This is known as the ‘trading allowance’. Cash from getting rid of your old belongings isn’t likely to be taxable unless any individual item is worth more than £6,000. You can check if your additional income is taxable using HMRC’s tool.
5. Make your savings work hard and keep up to £1,000
Stick your cash in some of the best regular savings accounts or accounts with the best savings rates for lump sums and don’t worry about paying tax on the interest up to £1,000 if you’re a basic rate taxpayer and up to £500 for higher rate taxpayers. Additional rate taxpayers don’t have a personal savings allowance.
6. Low earners get an extra savings boost
If you don’t earn much but have a healthy amount in savings you could be entitled to an extra tax-free income. Earn less than the personal allowance of £12,570 from wages and pensions, and you get the starting rate for savings. This means the first £5,000 of interest on your savings is tax-free. You also get the full £1,000 personal savings allowance on top of that.
So in total you can make up to £12,570 from wages, and £6,000 in savings interest without paying any tax. However, for every £1 of non-savings income over your personal allowance, you lose £1 of your starting savings allowance, so if you earn £17,570 you lose the entire allowance altogether.
7. Premium Bond prizes are tax-free
Whether it’s £25 or £1 million, Premium Bond prizes are tax-free.
8. Keep all the interest on savings in a cash ISA
Savers can put up to £20,000 into a cash ISA in the current tax year and interest is completely tax-free. The allowance remains the same in the coming tax year, before dropping to £12,000 for people under the age of 65. And all withdrawals are tax-free. Be sure to shop around to get the best cash ISA for you.
9. Income from stocks and shares ISAs yours to keep
All income your investments make inside a stocks and shares ISA – bond income or dividend income, for example – is free of any tax. You can also withdraw all the money without paying tax on it. When you reach the life stage where you want to draw an income from your assets, having ISAs in the mix alongside taxed income, like pensions, can really keep your tax bill down.
10. Income withdrawn from a Lifetime ISA at age 60 or over is tax-free
Any money withdrawn from a Lifetime ISA (LISA) is tax-free – as long as you stick to the rules. The LISA is dual purpose; it can be used to build a deposit to buy a first home (in which case the cash will go straight into that at the point of purchase) or save for retirement, with access from age 60. With the retirement option, all withdrawals are tax-free, giving you another tax-friendly income stream. But take the money out under any other circumstances and you’ll pay a penalty.
11. Enjoy your £500 dividend allowance
If you have investments outside an ISA, the first £500 of dividend income is free of tax in the current tax year. This allowance has dropped dramatically since being introduced in 2016 and dividend tax rates have increased during that time too, making ISAs even more valuable for those using dividends to boost their income.
12. Make use of double couple allowances
There are financial benefits to being married. You can share assets between you and double the amount of money you can make before the taxman takes a slice. For example, you can share income-producing assets with your spouse, so you can both take advantage of your personal allowance, dividend allowance and ISA allowance. Or in the case of capital gains tax, if you sell an asset that you hold jointly, you can effectively double the potential tax-free gain you make on it.
13. Purchased life annuities can generate a tax-free income too
These are designed to provide a guaranteed income for life or over a fixed term, in exchange for a lump sum that’s not from a pension. Part of the income paid is deemed to be a return of your original investment and therefore is tax-free. The interest element of the income is taxable, but no tax will have to be paid if it falls within the personal allowance or personal savings allowance.
