Basic Income Tax

August 2021

Nick Craggs talks you through some basic income tax calculations.

Normally I would never write an article on tax computations, as very quickly it is out of date and wrong. However, as AAT have announced that all AQ2016 tax exams are going to be based on the Finance Act 2020 for the next two years I thought I would make the most of it!

Benjamin Franklin wrote in a letter to French scientist Jean-Baptiste Leroy on November 13, 1789: “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”

As you are reading PQ magazine, and not Funeral Director Monthly (yes, it does exist) I will assume it is tax which you are interested in.

Tax computations are probably the most vital part of the AAT Personal Tax exam; if you struggle with these, you will struggle to pass the exam. However, I am big believer that everyone should have a working knowledge of tax, even those people who have no desire to work in an accountancy practice. Even if you work in industry and spend your days calculating fixed overhead variances (God forbid!) you will be paid, and you will be taxed. So you need to know if you are paying the right amount of tax – whether it is too much or too little. It is not unheard of for the person running the payroll to make mistakes. Remember, you, the taxpayer, have a duty to pay the correct amount of tax.

The most common type of income, in the real world, and in the exam, is employment income. This is not just your wages or salary, but would also include any benefits in kind, such as company cars, bonuses, etc., and allows a deduction for any contributions made by yourself to an occupational (company run) pension scheme. Employment income counts as ‘non-savings income’, which is basically anything which isn’t interest or dividend income.

Non-savings income is taxed at three different rates: 20%, 40% and 45%, known respectively as the basic rate, higher rate and additional higher rate (sometimes called tax bands). You will hear people talking about being a higher rate taxpayer; this does not mean that they are taxed on all of their income at 40%. Tax is incremental and so it is only the amount of tax that falls into the higher rate band which is taxable at this rate.

Importantly, everyone receives a personal allowance, which for the majority of people in 2020/21 (The Finance Act 2020) is £12,500.

The personal allowance is the amount the taxpayer can earn before they start to pay tax. So, for example, if you earned £30,000 for the year, £12,500 would be covered by the personal allowance and therefore would be tax free, while the remainder of £17,500 would be taxable. This is called the taxable income.

I have previously mentioned tax bands; there are three tax bands and the amount of taxable pay which falls into each band is taxed at the appropriate rate. For 2020/21, the basic rate tax band is £37,500, so any non-savings taxable income which falls into this band is taxed at 20%.

In our previous example, where you were paid £30,000 you would be entitled to £12,500 tax free, which leaves £17,500 to be taxed. This is all below the basic rate band of £37,500, so this is all taxed at 20%. Therefore the total tax liability will be 20% x £17,500 = £3,500.

The complication comes when someone has more taxable income than is covered by the basic rate band. Let’s assume you are awarded a pay rise and so you now earn £55,000. You can still earn £12,500 tax free, which leaves taxable pay of £42,500. The basic rate band is £37,500, so you will have £5,000 which is not covered by the basic rate band, and this will fall into the higher rate band.

You will be taxed at 20% on £37,500 in the basic rate band giving a tax liability of £7,500. You will also pay tax of 40% on the part of your income which falls into the higher rate bracket – £5,000. This will then be taxed at 40%, giving an additional tax liability of £2,000 (£5,000 x 40%). Therefore, the total tax liability on £55,000 is £2,000 + £7,500 = £9,500.

Note that only the amount which is in excess of the personal allowance and the basic rate band is taxed at 40%. The taxpayer still receives the £12,500 personal allowance and still only pays 20% tax on the first £37,500 of their taxable income; this is the incremental nature of tax.

If you follow the tax computation proforma, and ensure that you tax your non savings income first, your savings income second and your dividend income last then this will help you go a long way in passing your tax exam.

• Nick Craggs is First Intuition’s AAT Distance Learning Director