This is one of the most common questions that we get asked, especially from start up businesses.
On the face of it, it seems like a simple enough question, but can be tricky to answer if a client has various sources of income! We will answer the basics within this article, but we can't cover every scenario as there are always some slight oddities and exceptions to the rule when it comes to tax!
One of the key things to remember is that you are taxed differently depending on how you operate your business, so the first question to ask is…
How am I taxed?
If you operate your business as a sole-trader or partnership, then you are subject to tax on any profits which are made. You might not have withdrawn all these profits from your business account into your private one, but will still be taxed on profits as they are made.
If you operate your business as a Ltd Company, then the company itself will pay tax on the profits it makes, with you being taxed only on any money withdrawn from the company.
So, the method in which you get taxed is very different depending on how you operate, which could influence the way in which you choose to trade.
If you operate as a sole trader or partnership (i.e. are self employed), then it's more likely that you will need to consider National Insurance as well as tax, which we discuss on our next blog post.
How much can I earn before I pay tax?
Everyone has a personal allowance, which is the amount you can earn (from any source) before you start to pay tax.
For the current tax year 2019/20 this is £12,500.
How much can I earn before I become a higher rate tax payer?
If you want to remain a basic rate tax payer, then your earnings cannot exceed a total of £50,000 in the current tax year.
How much tax you pay will depend on the different types of income that you have. As mentioned above, the first £12,500 is tax free.
Most other additional income is taxed at 20% (salary, rental income, trading profits)
Dividend income is taxed at a lower rate of 7.5% (after the dividend allowance, the first anomaly!)
Employment earnings of £40,000
First £12,500 is tax free
Remaining £27,500 is taxed at 20% = £5,500
If this income was dividends, then the first £12,500 is still tax free. The next £2,000 is taxed at 0% (dividend allowance) with the remaining £25,500 being taxed at 7.5% = £1,912.50
How much can I earn before I become an additional rate tax payer?
Once your total earnings exceed £50,000 then you start to pay tax at a higher rate
Most additional income above these thresholds is taxed at 40% (salary, rental income, trading profits)
Dividend income is taxed at a lower rate of 32.5%
Employment earnings of £55,000
First £12,500 is tax free
Next £37,500 is taxed at 20% = £7,500
Remaining £5,000 is taxed at 40% = £2,000 (total tax of £9,500)
If this income was dividends, then the first £12,500 is still tax free. The next £2,000 is taxed at 0% (dividend allowance)
Next £35,500 is taxed at 7.5% = £2,662.50
Remaining £5,000 is taxed at 32.5% = £1,625.00 (total tax of £4,287.50)
What happens when I earn above £50,000?
Once you or your partner earn above £50,000 then any Child Benefit which you have received will start to be clawed back. The benefit is clawed back at a rate of 1% for every £100 of income on a sliding scale – once your earnings hit £60,000 then the full amount has to be repaid.
Note that earnings in this case is after you have deducted things like pension contributions (if no tax given at source) and gift aid
If you haven't been in receipt of Child Benefit for the tax year in question then no need to worry!
What happens when I earn above £100,000?
Once your earnings hits £100,000 (again, adjusted for any pension contributions and gift aid) then you start to lose your personal allowance.
This is lost at a rate of £1 for every £2 of income over £100,000 – once you reach income of £125,000 then your personal allowance is lost in full.
This would mean that you start to pay tax at 20% (7.5% for dividends) on any earnings up to the basic rate band of £37,500 with earnings above this taxed at 40% (32.5% for dividends)
What other anomalies are there?
You will have noticed reference to the dividend allowance above – the first £2,000 of dividend income is taxed at a rate of 0% - this is not an allowance in addition to the basic rate band (as seen in the examples above)
There is also a personal savings allowance (which is in addition to the basic rate band) and so the first £1,000 of savings income is tax free (this reduces to £500 if you are a higher rate tax payer)
There is also a Property Allowance of £1,000 and a Trading Allowance of £1,000 – these are covered in more detail in other blog posts
Trust income is also taxed differently, but this would need much more time to discuss than we have here!
So, there you have it – hopefully a straightforward guide for you to follow through! As ever, please contact us directly if you have any queries.