What You Need to Learn
- Distinguish between earned and unearned income
- Understand the personal allowance and income tax bands
- Calculate income tax on given salaries
- Know what National Insurance is and who pays it
- Explain how the PAYE system works
- Read and understand a payslip
- Know the purpose of P45 and P60 documents
- Understand how self-employed people pay tax
8.1 Types of Income
Income is money received by an individual. It can be split into two main categories: earned income (from working) and unearned income (from other sources).
| Earned Income | Unearned Income |
|---|---|
|
Salary — a fixed annual amount paid monthly (e.g. £30,000 per year = £2,500 per month) Wages — paid per hour worked (e.g. £12 per hour × 37.5 hours) Commission — a percentage of sales made (e.g. 5% of each sale) Overtime — extra pay for working beyond normal hours (often at 1.5× or 2× the normal rate) Bonus — an additional one-off payment for performance or at certain times of year |
Savings interest — money earned from bank/building society deposits Dividends — a share of company profits paid to shareholders Rental income — money received from letting out property State benefits — government payments such as Universal Credit, Child Benefit, State Pension Inheritance — money or assets received when someone dies |
Exam tip: Be clear on the difference between salary (fixed annual amount, paid monthly) and wages (paid per hour, can vary each week/month depending on hours worked). Both are forms of earned income.
Card Sort: Earned vs Unearned Income
8.2 Personal Allowance
Everyone in the UK has a personal allowance — the amount of income you can earn each year before you start paying income tax. For the 2024/25 tax year, the personal allowance is £12,570.
What this means: If you earn £25,000 per year, you only pay tax on £25,000 − £12,570 = £12,430. The first £12,570 is completely tax-free.
Important: The personal allowance reduces by £1 for every £2 earned above £100,000. This means someone earning £125,140 or more has no personal allowance at all — every penny they earn is taxed.
8.3 Tax Rates and Bands
Income tax in the UK is calculated in bands. You do not pay the same rate on all your income — different portions are taxed at different rates.
Personal Allowance: £0 – £12,570 = 0% (tax-free)
Basic Rate: £12,571 – £50,270 = 20%
Higher Rate: £50,271 – £125,140 = 40%
Additional Rate: Over £125,140 = 45%
Common mistake: Students often think that if you earn £60,000 you pay 40% on ALL your income. This is wrong. You pay 0% on the first £12,570, then 20% on the next £37,700, and then 40% only on the amount above £50,270.
Worked Example 1: Basic rate taxpayer
Emma earns £28,000 per year:
Personal Allowance (0%): £12,570 × 0% = £0
Basic Rate (20%): £28,000 − £12,570 = £15,430 × 20% = £3,086
Total income tax: £3,086 per year (£257.17 per month)
Personal Allowance (0%): £12,570 × 0% = £0
Basic Rate (20%): £28,000 − £12,570 = £15,430 × 20% = £3,086
Total income tax: £3,086 per year (£257.17 per month)
Worked Example 2: Higher rate taxpayer
James earns £65,000 per year:
Personal Allowance (0%): £12,570 × 0% = £0
Basic Rate (20%): £50,270 − £12,570 = £37,700 × 20% = £7,540
Higher Rate (40%): £65,000 − £50,270 = £14,730 × 40% = £5,892
Total income tax: £13,432 per year (£1,119.33 per month)
Personal Allowance (0%): £12,570 × 0% = £0
Basic Rate (20%): £50,270 − £12,570 = £37,700 × 20% = £7,540
Higher Rate (40%): £65,000 − £50,270 = £14,730 × 40% = £5,892
Total income tax: £13,432 per year (£1,119.33 per month)
Quick Check: Tax Bands
8.4 National Insurance
National Insurance (NI) is a tax on earnings that helps fund the State Pension, the NHS and other benefits. Both employees and employers pay NI contributions.
What does National Insurance pay for?
- State Pension — retirement income (you need 35 qualifying years of NI contributions for the full State Pension)
- NHS — free healthcare
- Jobseeker's Allowance — support when unemployed
- Maternity Allowance — payments during maternity leave
- Bereavement benefits — support after a spouse or partner dies
Employee NI rates (2024/25)
| Earnings Band | NI Rate |
|---|---|
| Below £12,570 per year (Primary Threshold) | 0% — no NI to pay |
| £12,570 to £50,270 per year | 8% |
| Above £50,270 per year | 2% |
Worked example: Emma earns £28,000.
NI on first £12,570 = £0
NI on £28,000 − £12,570 = £15,430 × 8% = £1,234.40 per year (£102.87 per month)
NI on first £12,570 = £0
NI on £28,000 − £12,570 = £15,430 × 8% = £1,234.40 per year (£102.87 per month)
8.5 PAYE (Pay As You Earn)
PAYE stands for Pay As You Earn. It is the system used by employers to deduct income tax and National Insurance from your pay before you receive it. This means you do not need to calculate or pay tax yourself — it is done automatically.
How PAYE works
- HMRC sends your employer a tax code that tells them how much tax-free pay you are entitled to
- Each pay day, your employer calculates how much income tax and NI to deduct
- The deductions are taken from your gross pay
- You receive your net pay (the amount after deductions)
- Your employer sends the deducted tax and NI to HMRC on your behalf
Tax codes
Your tax code tells your employer how much of your income is tax-free. The most common tax code is 1257L, which means you have a personal allowance of £12,570.
| Tax Code | Meaning |
|---|---|
| 1257L | Standard personal allowance of £12,570 (most common code) |
| BR | All income taxed at basic rate (20%) — used for second jobs |
| 0T | No personal allowance (e.g. income over £125,140 or new starter without a P45) |
| K code | You owe tax from a previous year that is being collected through your wages |
Exam tip: PAYE stands for Pay As You Earn, not "Pay As You Go". This is a very commonly tested point.
Fill in the Blanks: PAYE
8.6 Payslips
By law, every employee must receive a payslip each time they are paid. A payslip shows a breakdown of your earnings and deductions.
What a payslip shows
| Section | What It Shows |
|---|---|
| Gross pay | Your total pay before any deductions (salary + overtime + bonus + commission) |
| Income tax (PAYE) | The amount of income tax deducted based on your tax code |
| National Insurance | Your NI contribution deducted from earnings |
| Pension contributions | Your workplace pension payment (if enrolled — auto-enrolment is compulsory) |
| Student loan repayment | Deducted if you earn above the repayment threshold and have a student loan |
| Net pay | Your "take-home pay" — what you actually receive after all deductions |
| Tax code | The code HMRC assigns to determine your tax-free allowance |
| NI number | Your unique National Insurance number (format: AB 12 34 56 C) |
Sample payslip
TechCo Solutions Ltd
Employee: Emma Wilson | NI No: AB 12 34 56 C | Tax Code: 1257L
Pay Period: March 2025 | Pay Date: 28/03/2025
Employee: Emma Wilson | NI No: AB 12 34 56 C | Tax Code: 1257L
Pay Period: March 2025 | Pay Date: 28/03/2025
Basic Salary£2,333.33
Overtime (8 hours × £18)£144.00
GROSS PAY£2,477.33
PAYE Income Tax-£295.47
National Insurance-£128.57
Pension (5%)-£123.87
Student Loan (Plan 2)-£62.00
TOTAL DEDUCTIONS-£609.91
NET PAY£1,867.42
Key formula: Gross Pay − Deductions (Tax + NI + Pension + Student Loan) = Net Pay
£2,477.33 − £609.91 = £1,867.42
£2,477.33 − £609.91 = £1,867.42
Matching Activity: Payslip Terms
8.7 P45 and P60
These are important tax documents that employees receive from their employer.
| P45 | P60 |
|---|---|
|
When issued: When you leave a job What it shows: • Your tax code • Total pay and tax for the current tax year so far • Your employer's details • Your NI number Why it matters: • You give it to your new employer so they know how much tax you have already paid • Without it, you may be put on an emergency tax code and pay too much tax • Needed if you claim benefits (Jobseeker's Allowance) |
When issued: At the end of each tax year (after 5 April) What it shows: • Your total pay for the year • Total tax deducted for the year • Total NI paid for the year • Your tax code Why it matters: • Proof of income and tax paid • Needed for mortgage applications • Used to check you have paid the correct amount of tax • Needed for tax credit claims |
Exam alert: P45 = leaving a job. P60 = end of tax year. Do not confuse them. A common exam question is: "Which document would Jake need to give to his new employer?" Answer: P45.
Quick Check: P45 vs P60
8.8 Self-Employment Tax
Self-employed people do not have an employer to deduct tax for them. Instead, they must calculate and pay their own tax through self-assessment.
How self-assessment works
- Register with HMRC as self-employed
- Keep accurate records of all income and business expenses throughout the year
- Complete a self-assessment tax return after the end of the tax year (5 April)
- Calculate the tax owed (income tax on profits, not total revenue)
- Pay the tax owed by the deadline (31 January for online returns)
National Insurance for the self-employed
| NI Class | Who Pays | Amount (2024/25) |
|---|---|---|
| Class 2 | Self-employed people earning above £12,570 | £3.45 per week (flat rate) |
| Class 4 | Self-employed people on profits | 6% on profits between £12,570 and £50,270 2% on profits above £50,270 |
Employed vs self-employed: key differences
| Feature | Employed | Self-Employed |
|---|---|---|
| Tax collection | PAYE — employer deducts tax automatically | Self-assessment — you calculate and pay your own tax |
| NI class | Class 1 (employee rate) | Class 2 and Class 4 |
| Tax return | Usually not required | Must complete a self-assessment return each year |
| Expenses | Limited allowable expenses | Can deduct business expenses from profits before tax |
| Pension | Auto-enrolled in workplace pension | Must arrange own pension |
| Sick pay | Entitled to Statutory Sick Pay | No sick pay — must have own insurance |
Important: Self-employed people pay tax on their profits (income minus business expenses), not on their total revenue. For example, if a freelance designer earns £40,000 in revenue but has £8,000 in legitimate business expenses (software, equipment, travel), they pay tax on £32,000 of profit.
True or False: Pay and Tax
Flip Cards: Key Terms
Practice Quiz: Pay and Tax
Summary
| Key Term | Definition |
|---|---|
| Gross pay | Your total pay before any deductions (tax, NI, pension) |
| Net pay | Your "take-home pay" after all deductions have been made |
| Personal allowance | The amount you can earn tax-free each year (£12,570 for 2024/25) |
| PAYE | Pay As You Earn — the system where employers deduct tax and NI before paying you |
| Tax code | A code (e.g. 1257L) that tells your employer how much tax-free income you are entitled to |
| National Insurance | A tax on earnings that funds the State Pension, NHS and other benefits |
| P45 | A document received when you leave a job, showing your pay and tax for the year so far |
| P60 | A document received at the end of the tax year, summarising your total pay and tax for the year |
| Self-assessment | The system self-employed people use to calculate and pay their own tax |
| Basic rate | 20% income tax on earnings between £12,571 and £50,270 |
| Higher rate | 40% income tax on earnings between £50,271 and £125,140 |
| Additional rate | 45% income tax on earnings over £125,140 |
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