A short while ago here at Brand Financial Training, we had a telephone call from somebody studying for CF2 Investment and risk. They were querying at what stage higher rate tax becomes payable and revealed a fundamental misunderstanding of how income tax is calculated. We did of course explain the topic to them, and helped them to understand the calculation process, but it brought up such an important issue that we decided we’d write this article about income tax. Note that this relates to tax year 2008/09 which is examinable by the CII up to the end of August 2009.We’ll start by looking at the basics, before delving a little deeper.
In the 2008/09 tax year anybody under 65 – including children – has a personal allowance of £6,035. This means that the first £6,035 of income that they have is FREE of income tax. For anybody over the age of 65 there is an additional age allowance. If you are between the ages of 65 and 74 the personal allowance increases to £9,030. And for anybody over 75 this increases again to £9,180. However, if you have income of over £21,800 and are aged over 65, the age allowance is reduced by £1 for every £2 that income exceeds £21,800. This can never be reduced below the normal single person’s allowance.
Any income over a person’s personal allowance is subject to income tax. There are 3 separate bands – starting rate, basic rate and higher rate tax.
Let’s look at earned income first – that’s income from work or pensions.
The starting rate tax band where you only pay 10% is only relevant for people where their taxable non-savings income is under £2,320. For income between £2,320 and £34,800 above their personal allowance their income is charged at 20% which is the basic rate tax band, and anything over £34,800 above the personal allowance is charged at 40%. Anybody with income in this band is a higher rate taxpayer.
Here’s an example.
Mrs Lindam earns £45,000. Assuming she has no other income, calculate her tax liability for 08/09
Mrs Lindam earns over £40,835 so is a higher rate taxpayer.
Her personal allowance is £6,035. This amount will be free of tax.
The next £34,800 will be taxed at 20%.
For the remainder, she will be taxed at 40%
Already accounted for £6,035 + £34,800 = £40,835
£45,000 – £40,835 = £4,165 taxed at 40%
| Tax Due | ||
| £6,035 | No Tax | Nil |
| £34,800 | Taxed at 20% | £6,960 |
| £4,165 | Taxed at 40% | £1,666 |
| £45,000 | £8,626 |
Interest on Bank Accounts
Now let’s look at interest earned on bank accounts. This is taxed at 10% for starting rate taxpayers and is only relevant for people where their taxable non-savings income is under £2,320. Interest is charged at 20% for basic rate taxpayers and 40% for higher rate taxpayers. 20% tax is deducted at source, however non taxpayers can reclaim this or can fill out HMRC form R85 which so that the 20% tax is not deducted at source. Starting rate taxpayers who have taxable non-savings income under £2,320 can reclaim 10%, basic rate taxpayers have no more tax to pay and higher rate taxpayers have a further 20% to pay through their self assessment tax return. This means that higher rate taxpayers pay a total of 40% tax on interest.
Fixed Interest Securities
What about tax on fixed interest securities? This is classed as savings income and is subject to the same rates as tax on bank and building society deposit accounts. So, if an investor has non-savings income of less than £2,320 which is the starting rate limit for savings, then their savings income will be taxed at 10% up to the savings limit of £2,320. Tax is then charged at 20% for basic rate taxpayers and 40% for higher rate taxpayers.
Interest is usually paid gross unless the security is a Gilt, in which case the investor may have chosen to have 20% tax deducted at source. Where tax is due and it hasn’t been deducted at source, the investor must pay this through their self assessment tax return.
Equity Income
Income from equities is called dividend income. Any dividend paid is paid with a 10% tax credit. So if Joe Bloggs receives a dividend of £90, he has already had 10% tax deducted. So the actual gross dividend amount was £100. If you are a non, starting rate or basic rate taxpayer you cannot reclaim this 10%. If you are a higher rate taxpayer you will have an additional 22.5% to pay through your self assessment tax return. This is because the full amount of tax due on dividends for higher rate taxpayers is 32.5%.
Another Example
Raymond is aged 61 and earns £56,000 per annum. He receives net bank interest of £3,400 and net dividends of £2,910.
Calculate his income tax bill for tax year 2008/09 (including any tax deducted at source).
Raymond is a higher rate taxpayer.
His personal allowance is £6,035
His bank interest has been paid net of 20% tax. As a higher rate taxpayer, he has to pay an additional 20% to bring the total tax paid on interest to 40%.
His gross bank interest is £3,400 / 0.8 = £4,250. He therefore has already had £850 tax deducted at source.
He owes an additional 20%. £4,250 x 0.2 = £850
His dividend has been paid net of 10% tax. As a higher rate taxpayer, he has an additional 22.5% to pay to bring the total tax paid on dividends to 32.5%.
His gross dividend is £2,910 / 0.9 = £3,233.33. He therefore has already had £323.33 tax deducted.
He owes an additional 22.5%. £3,233.33 x 0.225 = £727.50
His income tax calculation is as follows:
| Tax Due | ||
| £6,035 employment income | 0% tax | Nil |
| £34,800 employment income | 20% tax | £6,960.00 |
| £15,165 employment income | 40% tax | £6,066.00 |
| £4,250 bank interest | 40% tax | £1,700.00 |
| £3,233.33 dividend | 32.5% tax | £1,050.83 |
| £63,483.33 | £15,776.83 |
His total income was £63,483.33 giving a total tax bill of £15,776.83
Note: He has already paid 20% tax on his savings interest, and 10% on dividends
£850.00 + £323.33 = £1,173.33
He therefore owes £15,776.83 – £1,173.33 = £14,603.50 in tax.
I hope that helps you out.
Need more help with calculations? We have available workbooks for CF1, CF2, CF5 and CF6 with workbooks for J01, J04, J05 and J06 due at the beginning of April 2009.
For more information visit www.brandft.co.uk/cf/all.asp for Certificate level exams, or www.brandft.co.uk/df/all.asp for Diploma level exams.
Don’t forget that all readers of TheParaplanner can get hold of free mock exam questions by visiting us at www.brandft.co.uk/TheParaplanner.asp All our mock questions are delivered as downloadable PDF documents which allows you to print them out and complete them whenever and wherever you wish – no need to sit at a PC and no waiting for the postman!
Good luck with your studies,
Catriona.
Catriona Brand
Brand Financial Training
Follow Brand Financial Training on twitter at www.twitter.com/CatrionaBrand
{ 1 comment… read it below or add one }
Great article – very informative and practically very useful.
Thank you
Kes