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How income tax is calculated

Contractors, like all taxpayers, have to pay tax on the income they receive from all sources. Calculating how much income tax a contractor pays depends on the source of the income, personal allowances and the tax rates in force.

Limited company contractors paying themselves a low salary and high dividend are more likely to pay income tax on their dividends. Umbrella company contractors, and those caught by IR35, will pay income tax on their salary. And sometimes contractors are asked to complete assignments on the agency payroll, which will also mean their earnings are subject to income tax.

Contractors often have other sources of income that have to be taken into account, such as earnings from savings and investments, rental income from buy-to-let properties, and possibly a pension.

What is income tax?

Very simply, income tax is a tax on an individual’s personal income. Anyone who is employed, like limited company and umbrella company contractors, self-employed sole traders and retired contractors receiving a pension or income from investments, must pay income tax.

Most types of income attract an income tax liability. So contractors drawing a salary, or taking earnings from employment, dividends, pension income, interest on savings and investments, rental income and income from trusts, must all pay income tax.

Certain types of income are classed as non-taxable income, and are exempt from income tax. Many, but by no means all, benefits are exempt. Some investment and savings income is also not liable for income tax, such as the interest from Individual Savings Accounts (ISAs).

Limited company contractors pay income tax on the employment income and dividends they receive from their company. Income tax is not paid on a limited company contractor’s gross fees, because that is company income on which the company eventually pays corporation tax on after expenditure has been deducted.

Employers are required by law to deduct income tax from an employee’s salary at source via the Pay As You Earn (PAYE) system. That means an umbrella company contractor has income tax deducted by the umbrella company employer before they are paid.

A limited company contractor paying themselves a salary should run a weekly or monthly payroll, deduct their income tax and pay it directly to HMRC at the end of each month, or, when HMRC’s Real Time Initiative (RTI) is in effect, before or on the day they are paid.

How income tax is calculated

To calculate income tax liability for a specific tax year, contractors should add together all of their taxable income, which for most contractors would include employment income, dividends, rental income and income from savings and investments.

The contractor then applies the personal allowance and income tax rate bands in force for the current tax year. The example below uses the 2013/14 allowances and rates, and involves:

  1. Personal allowance: everyone, including contractors, earning under £100,000 can earn up to £9,440 without paying any tax at all. This is known as a taxpayer’s personal allowance, and all subsequent tax is levied on income in excess of the personal allowance. A contractor’s personal allowance starts to reduce once they are earning more than £100,000
  2. Taxable income: This is a persons income earnings minus their personal allowance. It is the taxable income that is then taxed.
  3. Basic rate of income tax: The basic rate band is £32,010. So, for any taxable income earnings above £9,440 and below the higher rate tax threshold, which is £32,010, the contractor must pay a 20% rate of income tax.
  4. Higher rate of income tax: for taxable income earnings above £32,010 and below £150,000 a year, the contractor must pay a 40% rate of income tax
  5. Top rate of income tax: contractors earning a taxable income over £150,000 a year must pay the top rate of income tax, which is 45%.

Limited company contractors whose income is predominantly dividends would use different tax rates and calculations, because dividends have a tax credit applied.

Anyone who is employed, like limited company and umbrella company contractors, self-employed sole traders and retired contractors receiving a pension or income from investments, must pay income tax

Some contractors will also pay National Insurance Contributions (NICs), which are calculated based on their earnings from employment. That’s why most contractors who pay themselves a small salary and high dividend pay little or no NICs. NICs are not applied to dividends.

Example 1: an contractor earning £70,000, net of Employers NICs

Contractors who pay income tax are typically umbrella contractors and limited company contractors who are caught by IR35 and are paying themselves a salary, rather than making a deemed payment according to IR35 rules.

Using the Contractor Calculator PAYE-NI Net Salary Tax Calculator, the income tax calculation and breakdown, excluding NIC deductions and employer’s NICs, for a contractor earning a fairly typical contractor salary of £70,000 would look like this:

Tax band Percent Tax paid
Personal allowance 0% zero
Income tax 20% £6,402
Higher rate 40% £11,420
Top rate 45% zero
Total tax paid £17,822

Less income tax of £17,822, the contractor’s pay is £52,178. However, employees NICs of £4,614 must also be subtracted, so the contractor’s net pay is £47,559, or 68% of their gross income.

There is a further complication for contractors being paid a salary by their own limited company or an umbrella company, rather than an agency payroll: they have to fund their employers NICs.

A contractor paying themselves a salary via their own limited company has to pay an additional £8,597 in employer’s NICs. For umbrella company contractors, the employer’s NICs are taken from the contractor’s gross fees.

Example 2: reducing personal allowances and top-rate taxpayers

The calculation becomes more complex when the contractor is earning more than £100,000. Once this threshold has been reached, contractors gradually lose their personal allowance, which reduces by £1 for every £2 of income above the £100,000 threshold. That means contractors earning over £118,880 have no personal allowance. It also means there is a marginal rate of tax of 60% for taxable income from £100,000 to £118,880.

Looking at an example of a senior interim earning £200,000 net of Employers NICs in a chief executive’s role for a public body that’s caught by the office holder provision of IR35, and who decides to pay themselves a salary, the income tax calculations look like:

Tax band Tax paid
Personal allowance 0% zero
Income tax 20% £6,402
Higher rate 40% £47,196
Top rate 45% £22,500
Total tax paid £76,098

Less income tax of £76,098, the contractor is paid £123,902. As above, employee NICs of £7,214 must be also be subtracted leaving £116,687, or 58% of their gross earnings.

If a limited company contractor is not directly on their public sector client’s payroll, they must also fund their employers NICs, which total £26,537. The total cost to the employer is £226,537 when Employers NICs are included. An umbrella company contractor would have to fund employer’s NICs from their gross fee income.

Employees rarely consider the total cost of their employment to their employer, which includes employer’s NICs plus the cost of benefits such as pensions and health insurance. In both of these examples, the contractor has to fund the full cost of employment, either through their limited company or the gross fees paid to their umbrella company.

Published: 16 April 2013

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