Tax is a huge subject. Accountants and financial advisers have their work set out for them in helping the population to get their head around it. The aim of this piece is to try and explain the basics of tax in a straightforward manner, and dispel some of the myths surrounding it…
Why should I pay tax?
Tax has become a dirty word – it is easy to forget why we pay it. Whatever your politics or feelings on the matter, for us to maintain the status quo of the country, we must pay tax to finance government expenditure on public goods and services: law and public order, health care, education and infrastructure to name but a few.
How much tax should you pay?
But it is vital to ensure that you are paying the correct and fair amount. Mention tax rates to most people and their eyes will glaze over. This is mostly due to the fact that while we all pay tax, many people do not even understand how much they should be paying out of their earnings.
One of the easiest ways to grasp the tax system is to picture it as a cake.
- The base = £7,475, which is your personal allowance*. This means that you do not have to pay any tax on the first £7,475 of your earnings.
- The sponge = the next £35,000 which attracts Basic Rate Tax. This means that you pay tax of 20% on the next £35,000 of earnings.
- The icing = all earnings above the sponge attract Higher Rate Tax. This means that you pay 40% tax on all earnings over a total of £42,475
- The sprinkles = the layer of earnings over £150,000, which attract Super Tax. This means that you pay 50% tax on all earnings over a total of £150,000
So you keep all your base for yourself, you have to give away 20% of your sponge, 40% of your icing, and 50% of any sprinkles.
The most important thing to do is to check that you are not paying too much tax. Your tax code will tell you whether you are being taxed at the correct rate.
In the next few weeks both you and your employer will receive a ‘Notice of Tax Coding’, which will tell you what your tax code is for the next tax year starting on 6 April 2012. It will also explain how your code has been calculated.
For example, if your affairs are extremely straightforward – your tax code may be 747L. This means that you are getting your full personal allowance of £7,475 (as you can see the first three numbers of your code and your allowance are the same!).
Reasons why your tax code isn’t 747L
If the numbers are lower than 747, this means that you are not getting your full Personal Allowance. Some reasons could be:
- Benefits at work – eg. Private Medical Insurance or company car. The annual cost of providing these benefits is deducted from your tax code. This is because you are taxed on the benefit as if it were income.
- Additional personal income, such as income from renting out property. HMRC can tax you on this income via your tax code, by reducing your personal allowance.
If you have a different letter on your tax code – K for example – this is because HMRC believe your untaxed income and/or benefits (see above) are greater than your personal allowance.*
Check your code
Check your tax code. And don’t just do it once, check it every year, as your code may be altered if your circumstances change.
It is possible to have the wrong tax code for years – which could either mean that you are overpaying tax, or worse still that you are underpaying.
In the case of the former, you can claim back over-paid tax for up to six years – it could be a nice little windfall!
If you have underpaid tax for a number of years, you could be hit by a surprise bill – as unappealing as it may be, the sooner you look into it the better.
When people talk about paying tax, they often forget about National Insurance Contributions (NIC), which are payable on top of Income Tax.
The National Insurance cake is made up as follows:
- The base = £7,225. You do not have to pay any NIC on the first £7,225 of your earnings.
- The sponge = the next £35,250. You pay 12% NIC on this layer
- The icing = all earnings above the sponge attract 2% NIC. This means that you pay 2% National Insurance on earnings above £42,475
*New personal allowance figures will be implemented next year.
Henrietta Oxlade is an Independent Financial Planner with Radcliffe & Newlands and MyFamilyClub’s in-house finance sage! She has been advising individual clients since March 1988, which is why many of her clients consider her part of the family. If you want to contact Henrietta, email us on [email protected] and we’ll put you in touch.