Have you ever wondered how your gross income transforms into the take-home pay you receive every month?
If you earn £30k gross, your income net of tax will be £24k: 20% of your income goes in taxes.
If you earn £100k gross, your income net of tax will be £60k: 40% of your income goes in taxes.
In the UK your income is subjected to, not only increasing rates of Income Tax, but also National Insurance and Student Loan Repayments. All three are major factors that impact your earnings as your income levels rise.
Understanding how these components interact can not only help you better manage your finances but also shed light on the nuances of the UK's tax system. In this blog, we will take you on a journey through the intricacies of this system and provide factual financial data to illustrate how they shape your financial reality.
Meet the Players
Before we dive into the nitty-gritty, let's get acquainted with the key players in this financial drama for the tax year 2023/2024.
Income Tax: The bread and butter of government revenue, the UK follows a progressive income tax system, meaning the more you earn, the higher the percentage of tax you will pay. The income tax rates in the UK are as follows:
Personal Allowance: £12,570 tax-free amount. (Between £100,000 and £125,140 the personal allowance is reduced by £1 for every £2 earned).
Basic Rate (20%): on income between £12,571 and £50,270
Higher Rate (40%): on income between £50,271 and £125,140
Additional Rate (45%): Over £125,140
National Insurance (NI): NI contributions were originally designed to fund various social security programs, such as The NHS and state pensions. Similar to income tax, the rates rise with your income to a point (Note: there are different categories of NI contributions). The employee NI rates in the UK are as follows:
12% on earnings between £12,570 and £50,270
2% on earnings above £50,270
Student Loan Repayments: If you took out a student loan to finance your education, you will have to repay it once you start earning above a certain threshold. The student loan repayment thresholds are as follows:
Plan 1 (Pre-September 2012 loans): 9% on income over £22,015
Plan 2 (Post-September 2012 loans): 9% on income over £27,295
The Sweet Spot: Basic Rate Taxpayers
For those with lower incomes, life seems more straightforward. Basic rate taxpayers, who fall into the 20% income tax bracket, have a smaller percentage of their earnings deducted for taxes, leaving them with a relative higher take-home pay. NI contributions might not be too heavy on their wallets either. However, they might still have student loan repayments, if applicable.
Let's consider an example: Alice earns £30,000 annually. Here's how her income is affected:
Income Tax: £30,000 - £12,570 (Personal Allowance) = £17,430 at 20% = £3,486
National Insurance: (£30,000 - £12,570) at 12% = £2,092
Student Loan Repayment: (£30,000 - £27,295) at 9% = £244
Net Salary: £30,000 - £3,486 (Income Tax) - £2,092 (National Insurance) - £244 (Student Loan Repayment) ≈ £24,178
Percentage of income paid in tax: 20%
The Ascent: Higher Rate Taxpayers
As your income levels climb, so does your tax rate. Higher-rate taxpayers who fall into the 40% income tax bracket, experience a more significant reduction in their earnings due to income tax. NI contributions and student loan repayments also increase, adding to the overall deductions from their gross income.
Let's consider an example: Bob earns £100,000 annually. Here's how his income is affected:
Income Tax Basic: £50,270 - £12,570 (Personal Allowance) = £37,700 at 20% = £7,540
Income Tax High Rate: 100,000 - 50,270 = £49,730 at 40% = £19,892
NI Basic: (£50,270 - £12,570) at 12% = £4,524
NI Higher: (£100,000 - £50,270) at 2% = £995
Student Loan Repayment: (£100,000 - £27,295) at 9% = £6,543
Net Salary: £100,000 - £27,432 (Income Tax) - £5,519 (National Insurance) - £6,543 (Student Loan Repayment) ≈ £60,506
Percentage of income paid in tax: 40%
Reaching the Summit: Additional Rate Taxpayers
Once earning over £125,000 annually, the 45% income tax bracket kicks in. But, as you can see from the table at the end of this blog, there is 'a point' at which student loan repayments would no longer be applicable as the loan would have been paid off, therefore, the percentage of income paid in tax will fall.
Without student loan repayments to worry about, the percentage of income paid in tax tops-off at 47% ie even if you earn £50m, you will pay a maximum of 47% in Income Tax and NI, although I’m sure a good accountant will reduce this drastically!
Is the UK income tax system fair?
The question of whether the UK income tax system is fair is subjective and can vary depending on individual perspectives and opinions. The perceived fairness of the tax system can also be influenced by how tax revenue is used. If tax revenue is used to fund infrastructure such as roads, essential public services such as The NHS, and welfare programs that benefit society as a whole, it may be seen as fairer by some. But, the amount spent on these services and the direction of use is dictated by the government in power at the time….
The UK income tax system is generally considered progressive, which means that individuals with higher incomes pay a higher percentage of their income in taxes compared to those with lower incomes. This progressive structure aims to ensure that those who can afford to pay more contribute a larger share of tax revenue. Critics argue that the highest tax rates might not be high enough for the wealthiest individuals, as the percentage of income paid in tax does top-off at 47%, less whatever a good accountant can engineer. Others believe that too much taxation on high earners may stifle economic growth and entrepreneurship.
The UK income tax system provides a tax-free Personal Allowance which benefits lower-income earners and helps reduce their tax burden. It can also be argued that the introduction of student loan repayments effectively acts as an additional tax, and adds more strain on lower-income earners who never reach ‘the point’ of paying the loan off.
There are other tax reliefs and deductions available in the UK tax system, which can reduce the overall tax liability for certain individuals or specific activities. The fairness of these provisions can be a matter of debate, as some might argue that they disproportionately benefit certain groups.
Issues related to tax avoidance and evasion can also affect perceptions of the fairness of the tax system. When some individuals or corporations exploit loopholes to reduce their tax liability significantly, it may be seen as unfair by those who feel they are shouldering a heavier tax burden as a result.
Strategies for Optimising Your Earnings
Now that we understand how income tax, national insurance, and student loan repayments can affect gross income as earnings rise, let's explore some strategies to optimize your finances:
a. Pension Contributions: Contributing to a pension scheme can reduce your taxable income, potentially lowering your income tax liability. Rather than paying a 40% rate of tax, you can utilise your pension…
For example, John gets a pay rise taking him from £50,270 gross annual pay (just below the 40% tax barrier) to £60, 270. After Income tax on the £10k pay rise, the net income gain is reduced to £6k….or John can ask his employer to put the full £10k in his pension. John’s future self will thank him!
b. Salary Sacrifice Schemes: Some employers offer salary sacrifice arrangements, allowing you to exchange part of your salary for non-taxable benefits like childcare vouchers or cycle-to-work schemes.
c. Making Student Loan Repayments strategically: Depending on your overall financial situation, you may choose to accelerate your student loan repayments or stick to the minimum required.
d. Exploit other legal tax avoidance schemes.
As you can see from the factual financial data provided, navigating the intricacies of income tax, national insurance, and student loan repayments in the UK can significantly impact your take-home pay as your earnings rise. Understanding how these factors interact empowers you to make informed financial decisions and optimize your earnings effectively.