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The order in which income is taxed

With multiple income types, tax rates and allowances, it’s difficult to truly understand your own tax position, so this article provides a guide to the order in which income is taxed.

The first layer – Non-savings income

This is taxed first and includes income from all earnings such as P11d (benefits in kind), pension income, rental income, taxable state benefits and trading profits from self employment income.

The Personal Allowance is set against non-savings income, followed by savings then dividend income. If you are in receipt of the state pension the Personal Allowance would be set against this first, effectively making the state pension paid free of tax, although it is still classed as taxable income in the non-savings income category.

If you are over the age of 55 and flexibly access your pension, these payments are assessed in this category.

Second layer – Savings income

This includes any interest earned from bank and building society accounts, interest distributions generated from mutual funds (such as OEICs and unit trust investment holdings) and any offshore bond gains.

£5,000 attracts a zero rate if a person has non-savings income in the first layer and this does not exceed the combined total of their Personal Allowance plus £5,000.

The Personal Savings Allowance (PSA) was introduced from April 2016 and banks and building societies began paying all interest gross. A basic rate tax payer is entitled to a tax free band of £1,000 and higher rate taxpayers £500. Additional rate taxpayers have no tax free band. From April 2017, OEICs and unit trusts began paying interest bearing funds gross too. The PSA is applied at a zero rate and all interest accrued is still classed as income in this layer.

Whilst interest on cash deposits has been low for some time, if you exceed the tax free limit on your savings, tax becomes payable, but interest or gains made within an ISA are exempt.

Third layer – Dividends

Dividend payments from any share holdings, through a remuneration package or dividend paying mutual funds (such as OEICs and unit trust investment holdings) are taxed in this layer.

A dividend allowance was introduced in April 2016 which replaced the original 10% tax credit. The first £5,000 of dividend income is free of tax, but is essentially applied at a zero rate as it is still classed as income in this third layer. The allowance is due to reduce to £2,000 from April 2018, so anyone with substantial dividend income may be wise to revisit this before the new tax year.

Fourth layer – Onshore Bonds and redundancy payments           

This final layer includes gains made on any onshore bonds and the taxable part of any redundancy payment received.

If you have multiple sources of income, utilising all available allowances and exemptions is good planning. If you need help, contact our financial planning or tax team on 0808 144 5575.

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