How does income tax work?

How does income tax work?

Want to find out more about what income tax is, and how it works? Here at Payday Bad Credit, we take a look at everything you need to know about income tax so that you fully understand the process.

What is income tax?

Income tax is self-explanatory in many respects: it is a tax that you pay on your income. However, it is not necessarily the case you pay it on all kinds of income but most are included, such as:

  • Wages
  • Profits if you run your own business (this includes websites or apps that you run)
  • Benefits you may receive from your job
  • Income from a trust
  • Pensions

You may not have to pay tax if you are a live-in landlord and are eligible under the government Rent a Room scheme.

  • Rent income you have received if you are a landlord (unless you live on the premises and therefore get less than the limit for renting a room). The Rent a Room Scheme allows you to earn up to a maximum of £7,500 per year completely tax-free
  • Certain state benefits
  • Salary from your job
  • Interest from savings
  • Investment

The reason that you don’t typically pay income tax on all your income is that you may be eligible for a tax allowance. This allowance is a designated amount that you can have each year as tax-free. The Money Advice Service has listed the most common UK allowances for 2017/18:

  • Personal savings allowance of up to £1000
  • Marriage allowance of £1,150 (reminder: 20% of this is given as a tax bill reduction)
  • Dividend tax allowance: £5,000
  • Income threshold for personal allowance (£100,000) this is reduced by £1 for every £2 above the threshold
  • Personal allowance: £11,500 and follows the same rules as the above allowance

There are also other things that you do not pay tax on, as stated on the GOV.UK website, such as:

  • Income from National Savings Certificates or Individual Savings Accounts (ISAs)
  • If you are self-employed, the first £1000 worth of income as it categorised under your trading allowance
  • Certain state benefits such as Working Tax Credit, Child Tax Credit, Personal Independence Payment, Disability Living Allowance, Housing Benefit, Pension Credit and Maternity Allowance.
  • Premium bond wins
  • National Lottery wins

How do I pay income tax?

PAYE system


If you are employed, you will pay income tax through deductions of your earnings via the PAYE system.

Not everyone pays income tax in the exact same way. However, the majority of people in the UK tend to pay through PAYE. This means that your employer (or alternatively, your pension provider) uses PAYE to deduct income tax and national insurance contributions prior to paying your wages. The tax code that you are on informs your employer or pension provider the exact amount that they will need to deduct.

The tax code that is given to your employer or pension provider is through HMRC who inform them which tax code to use. The tax code will start with a number and end with a letter, wit 1185L being the most frequently used.

The numbers are worked out in the following way:

  • Your tax-free personal allowance is calculated by HMRC
  • Other income that hasn’t been tax, as well as the value of job benefits (e.g having a company car), are also added up
  • Income that hasn’t been taxed is then taken away from the personal allowance you have, the remaining amount is the tax-free income you are allowed yearly
  • The very last digit in the tax-free income amount is then removed

Each letter in a tax code has meaning and refers to both your financial situation as well as your personal allowance. To find out what each of them means you can look at the GOV.UK website.

Self-assessment tax returns

If you are self-employed or have a high income, it is likely you will have to pay income tax and national insurance in a different way, by filling in a Self Assessment form that is filled in and returned to HM Revenue and Customs (HMRC)  each year. In other words, the self-assessment form is a tax return form.

Tax on state benefits

As we have previously mentioned, tax is not exempt on a large number of state benefits. The tax code you have will take into consideration any taxable state benefits you have, and deduct them automatically from other income you have.

Nevertheless, you may find that HMRC will contact you directly if you have a state pension and this is also your only source of income too. If you do owe income tax, they will inform you and you may then to need to fill in a self-assessment form.

What is income tax used for?


Your income tax contributions help with a number of different public services, including the NHS.

You may be wondering what exactly the income tax you pay each month is contributing to. This money is collected on behalf of the government through HMRC In order to improve public services across the country. This includes things such as providing additional funding for:

  • The welfare system
  • Investment in public projects
  • Housing
  • Education
  • The NHS
  • Roads
  • Railways

How do I know how much income tax I need to pay?

We have previously mentioned very briefly about tax codes, and this is where we will go into further detail about them as well as the different tax bands. In summary, income tax is separated into a number of tax bands based on the income you receive. If you are living in Scotland though, the tax rates work slightly differently.

In terms of the rest of the UK, these are the current income tax bands:

  • 0 %: you will pay no income tax if your yearly income is between £0 to £11,850
  • 20%: this is considered to be the ‘basic rate’ tax band, so you earn between £11,851 and £46,350 and will, therefore, pay 20%. Remember that the tax is applied to all income over £11,850, so not money earned before this
  • 40%: you will pay 40% income tax if you earn annually between £46,351 and £150,000
  • 45 %: this is the top tier tax band, meaning that you will pay 45% income tax if you earn over £150,000 each year.

Daniel is a loans expert based in London and has been working in the payday loans industry since 2010.