The 6 Steps for Working Out Income Tax

Here, you will find a useful step-by-step that will aid CII AF1 candidates in remembering how to determine income tax liability – of interest to those studying for any of the CII R03, R06, AF1 or AF5 exams.

This article is relevant to examinable tax year 2016/17.

When faced with an income tax calculation, particularly in an AF1 exam, it’s good to remember these six steps so that none of the detail in the case study gets forgotten.

Step 1

Add up all of the person’s earned and unearned income.  This includes salary, bonus, self-employed profits, any taxable pension income, rental income, as well as savings interest and dividends.  If the client has any benefits in kind, you would also add them in here, usually next to the salary.

At the moment, some interest payments still need grossing up; not everything is paid gross yet.  So be careful with interest payments from unit trusts, corporate bonds etc and gross them up by dividing by 0.8.

At this stage, it’s a good idea to get into the habit of setting out the various types of income in the order that they are taxed so:

Although earned and savings income are taxed at the same rates, dividends aren’t, so getting into the habit of separating them out in this way will help to ensure the correct rates are applied.  Remember too, we now have the Personal Savings Allowance and the Dividend Allowance, and these are more easily applied when the income is shown in columns.

Step 2

Make deductions for things like business expenses, contributions to defined benefit schemes and interest on certain business loans.

Step 3

This is where we take off the personal allowance, remembering to adjust it if the client earns more than £100,000.

Step 4

Determine whether the client has made any gift aid donations or net pension contributions.  If they have, we gross them up and increase the basic rate band (and higher rate if applicable) by the grossed up figures to give additional income tax relief.

Step 5

It’s time to calculate the tax.  Remember we have 20%, 40% and 45% for earned income and 0%, 7.5%, 20%, 32.5%, 38.1%, 40% and 45% for unearned income!

Step 6

Now that we’ve worked out the income tax liability, Step 6 is where we can deduct any tax reducers.  The married couples allowance is a tax reducer, so watch out for the ages of the clients to see if they are eligible. Also check to see if there are any investments into VCTs, EISs and SEISs, because if so, the income tax relief comes off here as well.  The transferable amount of personal allowance is also taken off at this point if that applies.

So there you have it, the six steps to working out an income tax liability – in a future post, we’ll put it into practice!

Click here to download this helpful step-by-step instruction. Or why not share with your colleagues and/or followers on LinkedIn or Twitter?

Grab the resources you need!

If you’re studying for your CII AF1 exam, and you want to achieve stellar results, you’ll need to be prepared. 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 taster resources for R03 R06, or AF5 if you’re revising for one of those exams.

Over to You…

Did this help to clarify for you the steps required in determining income tax liability?