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Tax

What is Income Tax?

Income Tax is the tax paid on most types of income - salary, dividends, rental income, self-employment profits.

Current Rate (2025/26)

20% basic (£12,571-£50,270), 40% higher (£50,271-£125,140), 45% additional (over £125,140)

Example

Earn £60k salary. Pay 20% on £37,700 (£7,540) + 40% on £9,730 (£3,892) = £11,432 total.

Key Dates

Collected through PAYE or Self Assessment

How Income Tax Works in Practice

Income Tax is the UK's primary tax on earnings and applies to almost all forms of income you receive. The main types of taxable income include employment income (salary, wages, bonuses), self-employment profits, pension income, rental income, savings interest (above your Personal Savings Allowance), and dividends (above your Dividend Allowance). Different types of income are taxed at different rates and in a specific order.

For 2025/26, the tax bands for England, Wales, and Northern Ireland are: the Personal Allowance of £12,570 (income tax-free), the basic rate of 20% on income from £12,571 to £50,270, the higher rate of 40% on income from £50,271 to £125,140, and the additional rate of 45% on income above £125,140. Scotland has its own rate bands with starter, intermediate, and advanced rates. The Personal Allowance is tapered by £1 for every £2 of income above £100,000, meaning it is completely lost at £125,140.

Dividend income sits on top of other income but is taxed at lower rates: 8.75% (basic), 33.75% (higher), and 39.35% (additional). The first £500 of dividend income is covered by the Dividend Allowance and is tax-free. Savings income has its own rates too, with the Personal Savings Allowance providing £1,000 tax-free interest for basic-rate taxpayers and £500 for higher-rate taxpayers.

For company directors, understanding Income Tax is crucial for tax planning. The combination of salary (subject to Income Tax and National Insurance) and dividends (subject to dividend tax rates but not NI) is the most common way to extract money from a limited company. Setting your salary at the optimal level -- typically around the NI Secondary Threshold or the Personal Allowance -- and taking the rest as dividends can save thousands in tax each year.

Step by Step

Income Tax is collected in two main ways. Employment income is collected at source through PAYE (Pay As You Earn), where your employer deducts tax before paying you. Your tax code determines how much tax-free income you get each pay period. Self-employment income, rental income, and other untaxed income is collected through Self Assessment, where you file a tax return after the end of each tax year.

The tax calculation stacks your income in a specific order: non-savings income first (salary, self-employment, pensions, rental), then savings income, then dividend income. Each band is used up in this order, so dividends effectively sit at the top of your income stack. This ordering matters because dividend rates are lower than employment income rates at each band.

If you are employed and also have other income, HMRC may adjust your tax code to collect the additional tax through PAYE, or you may need to file a Self Assessment return. You must file Self Assessment if your income exceeds £150,000, you have untaxed income over £2,500, or you are a company director with taxable benefits.

Practical Tips

  • If your income is near £100,000, consider making pension contributions to stay below the threshold and keep your full Personal Allowance -- this is one of the most effective tax planning strategies available
  • As a director, set your salary at the optimal level for NI purposes and take remaining profits as dividends to minimise overall tax
  • Use your £500 Dividend Allowance and £1,000 Personal Savings Allowance each year -- they cannot be carried forward
  • Check your tax code at the start of each tax year -- incorrect codes are common and can result in under or overpayment of tax

Common Mistakes to Avoid

  • Not realising the Personal Allowance is tapered away between £100,000 and £125,140, creating an effective 60% marginal tax rate in that band
  • Forgetting that dividend income uses up your basic-rate band even though it is taxed at lower rates
  • Assuming Scotland uses the same tax bands as England -- Scottish rates differ significantly
  • Failing to register for Self Assessment when required, leading to penalties even if no tax is owed

Frequently Asked Questions

What income is tax-free in the UK?

The main tax-free amounts are: the £12,570 Personal Allowance, the £500 Dividend Allowance, the Personal Savings Allowance (£1,000 for basic-rate, £500 for higher-rate), ISA returns, and the first £1,000 of trading or property income under the trading and property allowances.

Why is there an effective 60% tax rate between £100,000 and £125,140?

Because your Personal Allowance is reduced by £1 for every £2 of income above £100,000. This means each additional £1 of income effectively costs you 40p in tax plus 20p in lost Personal Allowance, totalling 60%. Pension contributions can bring your income below £100,000 and restore the full allowance.

Do I need to file a Self Assessment return as a company director?

You must file if you receive any untaxed income, such as dividends above the £500 allowance, rental income, or other investment income. In practice, most directors who take dividends need to file. Even if all tax is collected through PAYE, HMRC may still require a return.

How are dividends taxed differently from salary?

Dividends are taxed at 8.75% (basic), 33.75% (higher), and 39.35% (additional) compared to 20%, 40%, and 45% for salary. Additionally, dividends are not subject to National Insurance, which saves both employee and employer NI contributions.

What is the Scottish Income Tax difference?

Scotland has its own rate bands including a 19% starter rate, 20% basic, 21% intermediate, 42% higher, 45% advanced, and 48% top rate. If you live in Scotland, these rates apply to your non-savings, non-dividend income regardless of where your employer is based.

Source: HMRC Income Tax guidance: https://www.gov.uk/income-tax-rates and HMRC Employment Income Manual (EIM00000+): https://www.gov.uk/hmrc-internal-manuals/employment-income-manual

Related Terms

Personal Allowance

The Personal Allowance is the amount of income you can earn each year before paying Income Tax.

Self Assessment

Self Assessment is the system HMRC uses to collect Income Tax from people who don't have all their tax deducted at source (via PAYE).

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