The recent abolition of the 10% income tax rate is constantly in the news this week as a political hot topic. In fact you are probably sick of hearing about it, but if you want to understand the basics of the actual tax involved, read on.

Budget 2007

In the Budget 2007, it was announced that the basic rate of income tax would decrease from 22% to 20%, and the 10% tax rate band would disappear. While this was actually announced over a year ago, the changes have only just come into effect for the new tax year (beginning 6 April 2008). So, what does this mean?

For 2007/2008, your income as an individual would be taxed as follows:

First £5,225 (the “personal allowance”) 0%

Next £2,230 10%

Next £32,270 22%

Any income above this 40%

It is usual for the limits of each band, and the personal allowance to increase year-on-year, such that if your income has not changed, you would pay slightly less tax. For the current tax year 2008/2009 (i.e. that beginning on 6 April 2008), the limits and the personal allowance have gone up as is usual, so combining this and the rate changes, your income in 2008/2009, will be taxed as follows:

First £5,435 (personal allowance) 0%

Next £36,000 20%

Any income above this 40%

Note that people aged 65 or over are entitled to higher personal allowances than shown, and these are the rates for income that is not savings income, dividends etc, but earnings such as salaries or the trading profits of a sole trader.

Looking only at the effects of the changes of rates, it follows that someone earning £7,665 (i.e. the new personal allowance + £2,230) will be the worst off - they are now paying tax at 20% rather than 10% on £2,230 i.e. £223 more than if the rates had not changed. (In fact, they will not pay £223 more than last year, as the increased personal allowance is in their benefit to the tune of about £46. It is these other changes which mean slightly different numbers may be quoted by various commentators).

As income increases above £7,665, the benefit of the lower 20% rate (compared with 22%) gradually compensates for this such that at an income level of £18,815 there is no effect of the change of rate, and at a level over this, an individual will be better off because of the rate changes.

The true picture

Unfortunately, doing this simplistic (!) example does not give the full picture - that’s tax for you.

There are several reasons for this. For example, changes to banding for national insurance rates mean that for people with earnings/trading profits above £34,840, national insurance will increase. The effects depend on whether you are an employee or self-employed, and indeed if you are an employer, but for a soletrader with no employees, we are talking about £400 in the worst case.

Additionally, there are various family tax credits and working tax credits available. As there are many conditions determining who qualifies for these, and at what level of income, it is impossible to factor in the effect of these here, except to say it’s worth checking whether you qualify as there are some common misconceptions. You do not have to have children, for example, to qualify for the working tax credit.

Similarly, the personal allowances for people aged 65 and over have increased more significantly than usual, and so individuals in this category will benefit.

While this is all quite messy, what is perhaps most surprising is why it has taken until now for such a fuss to be made, rather than when the changes were first introduced, but that’s politics and not for us to discuss. Given the ensuing row though, expect further changes next year…

And finally…

If you run your business through a company, you might be feeling smug, but you will not escape the income tax (and possibly national insurance) changes when it comes to the salary or bonus you are paid from the company. On the other hand, dividends still attract a tax rate of 10% up to the limit for higher rate tax (i.e. £41,435) but given that the rate of corporation tax for small companies is gradually increasing as we have discussed elsewhere, the company’s profits will have already been taxed at a higher rate before they are distributed.
As with all our information in The Business Lounge, this is not comprehensive tax advice, and may not apply to your specific circumstances; to discuss how these issues affect you, contact your accountant.