Income tax & NI

Income tax was introduced in 1799 as a temporary tax to help pay for the war against Napoleon. Although it was abolished after the battle of Waterloo it was soon re-introduced and we’ve been paying it every year since 1842.

In principle income tax is a fair, or progressive, tax. The amount you pay depends on how much you earn, and if you’re self-employed you only pay it on what’s left after taking off your business running expenses (more about that later). The first £12,570 of your total income each year is not taxed at all (this is your Personal Allowance), then you pay 20% on the next £35,700, 40% on the next £114,300, and finally if you earn more than £150,000 you get charged 45% on the rest.

These are the figures for the 2021/22 tax year. The equivalent figures for 2020/21 are here Tax Rates.

That is the basic picture although it is slightly more complicated than that because of some very strange tax rates on dividend income, and also very high earners gradually lose the Personal Allowance.

The tax rates and bands are slightly different in Scotland: low earners pay slightly less tax, while high earners pay more.

The government likes to pretend that National Insurance is not a form of taxation, and you will sometimes still see it referred to as NHI (National Health Insurance) although it hasn’t been called that since 1974. As far as you and I are concerned National Insurance (NI) is another tax on income. If you’ve previously been employed and paid NI through the PAYE system on your payslip you’ll find the system for the self-employed quite different. You now have 2 separate types of NI to pay.

Class 2 NI is a fixed amount of £3.05 per week and is payable annually with your income tax. Class 2 NI secures your right to the basic state pension.

On top of that you get charged Class 4 NI which is also worked out and collected with your income tax.  It’s charged at 9% on your business income after taking off your business expenses. The first £9,568 is not liable to NI and you only pay 2% on your business profits over £50,270.

Sorry if that all sounds complicated, there’s an example coming up if you want to see what happens in practice.

Income tax is paid to the Inland Revenue under a system called Self-Assessment.

What does self-assessment mean?

What it means is that it is your responsibility to tell the Inland Revenue you are liable to pay tax, it’s your responsibility to send in a Tax Return giving details of your income, and it’s your responsibility to pay the right amount of tax at the right time. You can’t sit back and wait for the HM Revenue & Customs to ask you.

The Self-Assessment Timetable

  • When you start in business you have to register with the tax office
  • The tax year ends on 5 April (yes, it’s a daft date – it’s all to do with the change from the Julian to the Gregorian calendar in about 1742.)
  • HMRC should send you a tax return in early April
  • If they don’t you have until 5 October to ask for one
  • If you send your tax return back (completed!) by 31 October then HMRC will work out your tax bill for you.
  • If you’re sending in a paper tax return you must send it in by 31 October.
  • You have until 31 January to submit your tax return if you do it online or if your accountant submits it online (so that’s 10 months to fill it in). And if you do it online the tax is worked out for you automatically.
  • Also by 31 January you have to pay any tax owing for the year that you’ve just done the Tax Return for.
  • And on 31 January you need to make a first payment on account for the following year. This is normally half the previous year’s total liability
  • And on 31 July you need to make a second payment on account.

Are there any penalties for not playing ball?

Just a few!

  • Interest is charged on any tax paid late. At the moment the interest rate is 3% per annum.
  • Any tax unpaid 30 days after it was due also attracts a 5% penalty, with a further 5% 5 months later and another 5% 6 months after that.
  • So if tax is paid 12 months late there will be interest of 3% and penalties of 15%. Ouch!
  • Failure to register on time gives rise to a penalty which provided it is just due to carelessness is 30% of the total tax.
  • There is a £100 penalty for not submitting a tax return on time, and if the return is more than 3 months late extra penalties kick in at £10 per day.

There are also penalties for sending in false information. More about that in the Nightmares section.