
"Half of people don't understand the basic principles of income tax". A recent poll by Tax Policy Associates found that 50% of respondents didn't understand the way that tax rates apply to income above a threshold, which is a fundamental principle of our income tax system.
The poll found that 50% of people thought that once you hit the higher rate threshold, the 40% higher rate applies to all your earnings, which isn't correct.
So what does it mean when we say that tax rates apply to income above a threshold?
Your income is split into three bands. Earnings up to £12,570, the current personal allowance, are tax free. Earnings between £12,571 and £50,269 are taxed at 28% and earnings over £50,270 are taxed at 42%. Each band of income is taxed at the relevant rate to calculate your tax bill.
This is really important, as the poll found that half of people believed that if you hit the £50,270 threshold then all of your income is taxed at 40% income tax. This misunderstanding would mean that there would be additional tax on your earnings to the £50,270 of around £12.5k - to be clear, that is completely incorrect but perhaps explains why some many people have a fear of becoming a higher rate taxpayer.
So how does it work? If you live in England and earn below £50,270 then for every additional £1 you earn you will pay an additional 28p in tax (20% income tax and 8% national insurance). If you earn £50,270 or above you fall into the higher rate band, and this means that for every £1 you earn over £50,270 you will pay an additional 42p in tax (40% income tax and 2% national insurance). It is only the income over £50,270 that pays 42p for each £1 earned; any income earned up to that £50,270 remains taxed at 28p for every £1.
Are you wondering why this is important? It used to be only a small number of people were higher rate taxpayers. However, by 2027/28 it is estimated that 14% of adults will be in the higher rate tax band, which is around a quarter of all taxpayers. This will therefore impact on a lot of households.
There are lots of anecdotes of people turning away work because they are worried they will enter the higher rate tax band and it will cost them large amounts of money. As you can hopefully see from this, that simply isn't true.
Did you understand how the higher rate tax worked? What other topics do you feel might be misunderstood?
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