Chapter 2
Income Tax
How UK income tax bands work, National Insurance, and reading your payslip.
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You don't pay 20% on everything
This is the single biggest misconception about income tax in the UK. If you earn 35,000, you do not pay 20% on the whole lot. Tax is calculated in bands -- like filling buckets from the bottom up.
Here's how it works:
| Band | Income range | Rate |
|---|---|---|
| Personal Allowance | 0 -- 12,570 | 0% |
| Basic Rate | 12,571 -- 50,270 | 20% |
| Higher Rate | 50,271 -- 125,140 | 40% |
| Additional Rate | 125,141+ | 45% |
Your first 12,570 is completely tax-free. This is your Personal Allowance. Every penny above that, up to 50,270, is taxed at 20%. Only the portion above 50,270 gets taxed at 40%. And so on.
Think of it like water filling a series of tanks. The first tank (12,570 litres) is free. The next tank (37,700 litres) costs 20p per litre. You only start paying 40p per litre once those first two tanks are completely full.
Diagram: Tax Band Waterfall
On 35,000:
- First 12,570 = 0 tax
- Next 22,430 (from 12,571 to 35,000) at 20% = 4,486 tax
- Total tax: 4,486 (effective rate: 12.8%, not 20%)
National Insurance
National Insurance (NI) is the other deduction on your payslip. It's technically separate from income tax, but it comes out of your pay the same way. As an employee, you pay:
- 8% on earnings between 242 and 967 per week (roughly 12,570 to 50,270 per year)
- 2% on anything above 967 per week
Your employer also pays NI on top of your salary -- 15% on everything above 96 per week. You never see this on your payslip, but it's a real cost of employing you. This becomes very relevant if you ever hire someone (Chapter 13).
Jargon Buster: National Insurance A tax on earnings that funds the State Pension and some benefits. You need a minimum number of qualifying years (currently 35) to get the full State Pension. Despite the name, it's not really "insurance" -- it's a tax collected alongside income tax.
Your tax code
Your tax code appears on your payslip and tells your employer how much tax-free income you get. The most common code is 1257L.
The number part (1257) is your Personal Allowance divided by 10. So 1257 means 12,570 of tax-free income. The letter (L) means you're entitled to the standard Personal Allowance.
Other letters you might see:
| Code | Meaning |
|---|---|
| L | Standard Personal Allowance |
| M | You've received 10% of your partner's allowance (Marriage Allowance) |
| BR | All income taxed at Basic Rate (no allowance -- usually a second job) |
| 0T | No Personal Allowance (allowance used up or employer doesn't have your details) |
| K | You owe tax from a previous year, being collected through your code |
If your tax code is wrong, you'll pay too much or too little tax all year. Check it on your payslip. If it doesn't look right, call HMRC on 0300 200 3300 or check your Personal Tax Account at gov.uk.
Decoding your payslip
Here's what every line on your payslip actually means:
| Line | What it is |
|---|---|
| Gross Pay | Your full salary before anything is taken off |
| Taxable Pay | Gross pay minus pension contributions and any salary sacrifice |
| Tax | Income tax calculated on your taxable pay using the bands above |
| NI | National Insurance -- 8% on the band between the thresholds |
| Pension | Your contribution to your workplace pension (minimum 5% under auto-enrolment) |
| Student Loan | Repayment on Plan 1 (9% above 24,990), Plan 2 (9% above 27,660), or Plan 5 (9% above 25,000) |
| Net Pay | What actually hits your bank account |
Jargon Buster: PAYE Pay As You Earn. The system where your employer calculates and deducts your tax and NI before paying you. You don't need to do anything -- it happens automatically. If you're employed and have no other income, PAYE means you probably don't need to file a tax return.
Diagram: Payslip Decoder
The 100,000 trap
If you earn over 100,000, your Personal Allowance starts to disappear. For every 2 you earn above 100,000, you lose 1 of your allowance. By the time you reach 125,140, your Personal Allowance is completely gone.
This creates a hidden tax band between 100,000 and 125,140 where your effective tax rate is 60% -- you're paying 40% income tax plus losing 20% worth of allowance. It's the highest effective rate in the entire system.
If you're approaching 100,000, pension contributions can bring your income below the threshold and restore your allowance. This is one of the few times tax planning makes a dramatic difference for employed people.
Real Scenario: Sam's payslip
Sam earns 35,000 per year in marketing. Here's Sam's monthly take-home:
| Item | Monthly | Annual |
|---|---|---|
| Gross salary | 2,916.67 | 35,000.00 |
| Income tax | -373.83 | -4,486.00 |
| Employee NI | -149.53 | -1,794.40 |
| Pension (5%) | -145.83 | -1,750.00 |
| Net pay | 2,247.48 | 26,969.60 |
Sam keeps about 77% of gross salary. The rest goes to tax (12.8%), NI (5.1%), and pension (5%).
Now look at Steve. Steve works for a landscaping company earning 28,000:
| Item | Monthly | Annual |
|---|---|---|
| Gross salary | 2,333.33 | 28,000.00 |
| Income tax | -257.17 | -3,086.00 |
| Employee NI | -102.53 | -1,230.40 |
| Pension (5%) | -116.67 | -1,400.00 |
| Net pay | 1,856.96 | 22,283.60 |
Steve keeps about 80% of gross salary. The lower salary means less falls into the 20% tax band, so a higher proportion comes home.
Key point: The jump from 28,000 to 35,000 is 7,000 gross, but only about 4,686 net. Every extra pound above the Personal Allowance loses 20% to tax and 8% to NI. A 7,000 pay rise is really worth about 5,040 in your pocket (before pension).
Cost Table: Take-home at different salaries
| Gross salary | Income tax | NI | Pension (5%) | Net pay | Effective tax rate |
|---|---|---|---|---|---|
| 20,000 | 1,486 | 594 | 1,000 | 16,920 | 7.4% |
| 25,000 | 2,486 | 994 | 1,250 | 20,270 | 9.9% |
| 30,000 | 3,486 | 1,394 | 1,500 | 23,620 | 11.6% |
| 35,000 | 4,486 | 1,794 | 1,750 | 26,970 | 12.8% |
| 45,000 | 6,486 | 2,594 | 2,250 | 33,670 | 14.4% |
| 55,000 | 8,486 | 2,994 | 2,750 | 40,770 | 15.4% |
| 75,000 | 16,486 | 3,494 | 3,750 | 51,270 | 22.0% |
| 100,000 | 27,432 | 3,994 | 5,000 | 63,574 | 27.4% |
NI calculated using annual approximation. Pension at 5% auto-enrolment minimum. Effective tax rate is income tax only as a percentage of gross.
Jargon Buster
| Term | Plain English |
|---|---|
| Gross pay | Your full salary before any deductions |
| Net pay | What actually arrives in your bank account |
| Personal Allowance | The amount you can earn tax-free each year (currently 12,570) |
| Tax code | A code on your payslip that tells your employer your tax-free amount |
| PAYE | Pay As You Earn -- the system where tax is deducted from your salary automatically |
| National Insurance | A tax on earnings that funds State Pension and some benefits |
| Auto-enrolment | The law that requires employers to put you into a workplace pension |
| Salary sacrifice | An arrangement where you give up part of your salary in exchange for a benefit (like extra pension), reducing your taxable income |