Income Tax Calculation Using the 6 Steps
In this blog post, we’re going to put the six steps to working out someone’s income tax liability into practice. This is useful knowledge for your CII R03 or AF1 exam preparation.
This article is relevant to examinable tax year 2023/24 and is correct as at 22 August 2023.
Scenario
Jackie is aged 45 and single. She is self-employed and has profits in this tax year of £105,000. She also receives dividends of £6,400, interest from her internet savings account of £800, and a payment from a purchased life annuity which includes an interest element of £2,000. Finally, she makes a pension contribution of £8,000 to her SIPP and an investment of £10,000 to an Enterprise Investment Scheme.
Step 1 – is where we add up the person’s earned and unearned income. Although earned and savings income are taxed at the same rates, dividends aren’t, so getting into the habit of separating them out will help to ensure the correct rates are applied. The only payment we need to gross up by 20% is the income element from the purchased life annuity of £2,000 as this is paid net of income tax at the basic rate.
| 1. Earned income | 2. Savings income | 3. Dividend income |
|---|---|---|
| £105,000 | £800 £2,500 | £6,400 |
Step 2 is where deductions can be made, e.g. for business expenses, contributions to defined benefit schemes and interest on certain business loans. We can ignore step 2 in our example.
Step 3 is where we deduct the personal allowance:
- Jackie has total income of £114,700 so we need to adjust this as it is more than £100,000.
- However, first we can deduct the gross pension contribution of £10,000 (£8,000 grossed up by 20%). £114,700 – £10,000 = £104,700.
- £104,700 – £100,000 = £4,700.
- Divide this by 2 to give £2,350.
- £12,570 – £2,350 means Jackie has a reduced personal allowance of £10,220.
Step 4 is where we see if the client has made any gift aid donations or net pension contributions. We’ve already established Jackie’s gross pension contribution is £10,000, meaning we can increase her basic rate band by this amount.
Step 5 is where we finally calculate the tax.
| 1. Earned income | 2. Savings income | 3. Dividend income |
|
|---|---|---|---|
| £105,000 | £800 £2,500 | £6,400 | |
| (£10,220) | £500 x 0% £2,800 x 40% = £1,120 | £1,000 x 0% £5,400 x 33.75% = £1,822.50 |
|
| £94,780 | |||
| £37,700 + £10,000 = £47,700 x 20% = £9,540 £94,780 - £47,700 = £47,080 x 40% = £18,832 | |||
| Total = £31,314.50 Minus tax deducted at source = £500 = £30,814.50 | |||
Step 6 is where we deduct any tax reducers. Jackie has made an investment into an EIS of £10,000 on which she can claim tax relief of 30%; this is deducted at this stage:
£30,814.50 – £3,000 = £27,814.50
We hope this has helped you to tackle any income tax calculation you may be faced with.
Grab the resources you need!
If you’re studying for your CII AF1 exam, and you want to feel more confident on exam day, grab our free taster to try out one of Brand Financial Training’s resources for yourself. Click the link to download the AF1 calculation workbook taster now.
Alternatively, you can download the taster for R03 if you are preparing for that exam.
