Taxes in the United Kingdom [2023] – A Complete Guide [Clear Finances]

Last updated on 7 de April de 2023

The UK is a truly unique country, with plenty to offer. For those interested in understanding how taxes work in the United Kingdom, we will carry out an in-depth but easy-to-understand analysis on the subject.

Introduction

The economy of the United Kingdom is one of the largest in the world. It is heavily integrated with the economies of the European Union, the United States and some of the most important emerging countries, such as India. Through the City of London, it also exercised a lot of influence in the financial world.

The UK has a reputation for having a high cost of living. And this may be especially true for those living in London, the South-East of England and Edinburgh.

At the same time, the cost of living in certain parts of the country, such as Northern England or Wales, is much lower.

According to WorldData.info, the average cost of living in the United Kingdom is about 7% higher than in the United States and 15% higher than in Germany.

Because some tax rates are dependent on how much money we make or how much we pay for certain things, we will see the original amounts in British Pounds (GBP) as well as the equivalent in US Dollars and Euros. For that, we will use an approximate exchange rate of £1 = $1.10/€1.10.

The tax rates we will see here are those valid for the 2023-2024 fiscal year, which begins in April 2023.

Taxes on Earned Income

We will kick off our analysis of taxes in the United Kingdom by looking at how labor income is taxed. It is subject to both social security contributions as well as income tax.

Most employers and employees in the UK must make social security contributions. Those are driven by the employee’s gross salary.

On the one hand, employers must pay the equivalent of 13.8% of the employee’s gross salary above £9,100 (£10,010/€10,010) per year in social security contributions. There is no maximum base or maximum contribution for these payments.

When it comes to employees, their social security contributions are subject to the following rates, based on their gross income:

0 to £12,570 ($0- $13,827/€0-€13,827): 0%
£12,570 to £50,270 ($13,827-$55,295/€13,827-€55,295): 12%
Over £50,270 ($55,295/€55,295): 2%

Thus, while social security contributions made by workers are not capped, they start to increase very slowly at a certain income level. This is because income tax rates increase at that point.

Income Tax

Income is also subject to UK income tax, which comes after social security payments. It follows a progressive structure, where the tax rate is higher for those with higher incomes:

Personal tax allowance: 0 to £12,570 ($0-$13,827/€0-€13,827) – 0%*
Basic tax rate: £12,571 to £50,270 ($13,827-$55,295/€13,827-€55,295) – 20%
Higher tax rate: £50,271 to £125,140 ($55,296-$137,654/€55,296-€137,654) – 40%
Additional tax rate: Over £125,140 ($137,654/€137,654) – 45%

It should be noted that the initial bracket of 0%, which corresponds to the personal tax allowance, enabling us to earn £12,570 tax-free every year, begins to diminish when the gross salary exceeds £100,000 ($110,000/€110,000).

For every two pounds above £100,000 in income, the personal tax allowance is reduced by one pound. The lost amount of the personal tax allowance is then taxed at 20%.

When the salary reaches £125,140, which is £25,140 above £100,000, the personal tax allowance is zero and we have to pay a rate of 20% on the first £50,270.

Everything we earn above £125,140 will be taxed at the higher rate of income of 45%.

It should be noted that the amounts used for social security contributions and income taxes, including the personal tax allowance, are all aligned to make the system simple.

Another thing worth mentioning is that the UK allows us to contribute £40,000 ($44,000/€44,000) of our pre-tax income every year to private pension funds. This helps reduce our tax bill at the end of the fiscal year.

Total Tax Burden on Earned Income

With the goal to understand the total tax burden on labor income, it is useful to compare total employment costs, including both gross salary and employer’s social security contributions, with the employee’s net income after their own social security contributions and income taxes.

We will do such an analysis for individuals at various income levels to assess the progressiveness of the overall system:

As we can see on the chart, the system is indeed progressive. Lower incomes are taxed at overall lower rate rates than middle incomes. And middle incomes are in turn taxes less heavily than higher incomes.

Capital Income Taxes

While essentially part of the income tax system, capital income and realized capital gains in the UK are taxed much differently than labor income. Therefore, it is necessary for us to analyze them separately:

Dividends

Income in the form of dividends is generally subject to income taxes in the UK. The rate we will have to pay will depend on our overall income, including other forms of income, as well as the amount of dividends we have received.

Thus, the first £1,000 ($1,100/€1,100) that we receive in the form of dividends every year is exempt from tax. Anything that exceeds that figure will be subject to the following dividend tax rates, depending on our marginal tax rate for labor income:

8.75% if we are basic tax rate payers and our marginal rate is 20%
33.75% if we are higher tax rate payers and our marginal rate is 40%
39.75% if we are additional tax rate payers and our marginal rate is 45%

Interest

What we receive in interest from either bank accounts or fixed income investments, such as bonds, may also be subject to taxation. This will depend on how much interest we have received and our other forms of income.

If our other income is less than £17,570 ($19,327/€19,327) per year, we can receive up to £5,000 ($5,500/€5,500) in interest tax-free.

However, if our other income is higher than £17,570 in that fiscal year, the tax-free amount for interest income will be less.

If our marginal tax rate is 20%, we can receive up to £1,000 ($1,100/€1,100) interest tax-free. If the marginal rate we pay is 40%, the interest tax-free amount will be as low as £500 ($550/€550). Finally, if we pay a marginal rate of 45%, we receive no interest tax-free allowance.

The interest we have received above our tax-free allowance will be added to our general income and subject to the same tax rates as labor income. Consequently, interest income may end up being taxed at 45%.

Rental Income

Net rental income is added to our other forms of income, including labor income, to calculate the applicable tax we have to pay. This means the marginal rate on net rental income will be 45% for additional tax rate payers.

One important caveat is that, while most expenses associated with the ownership and upkeep of our rental properties are tax-deductible, not all are. The main exception is mortgage interest expense and other mortgage-related expenses, such as origination fees.

Instead of being able to lower our taxable income by all costs associated with having a mortgage on the property, we receive a tax credit equivalent to 20% of those costs.

If we are higher or additional tax rate payers, paying a marginal tax rate of either 40% or 45%, a big portion of our mortgage expenses will not be tax-deductible. Let us illustrate this with an example.

If we spend £10,000 per year on mortgage interest, our net rental income will be calculated without taking that expense into consideration. This means tax income will be calculated without considering mortgage costs. We will simply receive a tax credit equivalent to 20% of that, which will lower the amount of income tax payable by £2,000.

This is much worse than having the option to reduce our taxable income by £10,000. This is because, by doing that, we would be able to save £4,000 or £4,500, depending on whether our marginal tax rate is 40% or 45%. This means most of the mortgage interest is not considered an expense we can offset against our taxes.

This places smaller landlords at a disadvantage relative to big landlords. This is because big landlords that operate through a corporation are allowed to deduct all their mortgage costs from their net rental income. In that case, they also end up paying corporation tax instead of income tax, reducing their tax even further.

Capital Gains

Realized capital gains may also be taxable in the UK.

For the 2023/24 fiscal tax year, all individuals can receive £6,150 ($6,765/€6,765) in tax-free capital gains. Anything that exceeds that figure will be taxed. Tax rates for capital gains will be lower for those at lower income levels.

If our marginal tax rate on other income is 20%, we must add our capital gains above £6,150 to our other income. If the sum is less than £50,270 ($55,297/€55,297), we will benefit from lower rates for those capital gains.

The reduced rates are 10% for all non-real estate assets, and 18% for real estate assets. The exception is our main residence, for which we almost never have to pay taxes.

For those who cannot benefit from the reduced rates, because their combined income exceeds £50,270, capital gains above the exempt amount will be taxed at 20% for most assets, and 28% for real estate assets, with the exception of the main residence.

Tax-Free Capital Income (ISA accounts)

Before concluding this section, it is worth mentioning that the United Kingdom has special savings and investment accounts that are completely exempt from taxes forever. They are called Individual Savings Accounts, and are known by the acronym ISA.

There are different types of ISAs. The most popular are Cash ISAs, which work like a savings account and allow us to receive interest tax-free, and Stocks & Shares ISAs, which are like brokerage accounts and allow us to invest in stocks, bonds, ETFs, etc. and receive dividends, interest and capital gains tax-free.

We can add £20,000 ($22,000/€22,000) every fiscal year to our ISA accounts. Everything we receive from within our ISAs will always be exempt from taxes: interest, dividends and capital gains.

If you want to learn more about how ISAs work, check out this section:
ISA

Stamp Duty (Real Estate Transfer Tax)

The purchase of a home usually comes with various expenses. We will focus on taxes here.

In the United Kingdom the purchase of a home may be subject to a tax called Stamp Duty. The amount payable depends on the purchase price of the property, whether it is our first purchase, and whether we already own another home.

For those buying a home for the first time, if the purchase price does not exceed £625,000 ($687,500/€687,500), the Stamp Duty will be very low.

In fact, the first £425,000 ($467,500/€467,500) of the transaction is fully tax-exempt. Therefore, if we buy a home for that amount or less, we will not have to pay any stamp duty.

If the purchase amount is between £425,000 and £625,000, we will pay 5% of the amount that exceeds £425,000.

If we buy a home, but it is not our first purchase, and we do not own any other home after that purchase, the Stamp Duty rates will be higher. Obviously, if we buy a new main residence with the intention of selling our previous main residence, those are the rates that will apply to us.

In this case, the amount to be paid in stamp duty will depend on the value of the transaction:

0 to £250,000 ($0-$275,000/€0-€275.000): 0%
£251,000 to £925,000 ($275,001-$1,017,500/€275,001-€1,017,500): 5%
£925,000 to £1,500,000 ($1,017,501-$1,650,000/€1,017,500-€1,650,000): 10%
Over £1,500,000 ($1,650,000/€1,650,000): 12%

Finally, if we buy a home with the intention of ending up owning two or more homes after that purchase, regardless of whether those homes are for our own use or to rent out to tenants, the stamp duty rates will be increased by 3% in all brackets:

0 to £250,000 ($0-$275,000/€0-€275.000): 3%
£251,000 to £925,000 ($275,001-$1,017,500/€275,001-€1,017,500): 8%
£925,000 to £1,500,000 ($1,017,501-$1,650,000/€1,017,500-€1,650,000): 13%
Over £1,500,000 ($1,650,000/€1,650,000): 15%

For this reason, those individuals who own several properties and wish to buy a luxurious house in the United Kingdom will have to face a very significant stamp duty payment.

VAT

Value-added tax (VAT) has to be paid whenever we buy goods and services in the United Kingdom.

There are three different VAT rates. The general VAT rate is 20% and applies to most goods and services not specifically subject to any of the reduced tax rates.

A reduced VAT rate of 5% is applied to electricity consumption and gas. This helps keep household bills in check.

Finally, certain goods and services are exempt from VAT as they are considered essential. This is the case for housing, most foods, children’s clothes and footwear, water supply, books, press, as well as sanitation and health services.

Corporation Tax

The main corporation tax rate in the United Kingdom from April 2023 is 25%. Prior to that date, corporation tax used be 19% only. This means corporate profits are more heavily taxed.

Small and medium-sized companies with annual profits of not more than £50,000 ($55,000/€55,000) still benefit from a reduced 19% corporate tax rate.

The tax increase from 19% to 25% was implemented with the goal to increase tax collection. This can be problematic for the United Kingdom, since it is difficult to compete against the Republic of Ireland, where the corporation tax rate is 12.5% and English is also the main language.

Conclusion

The United Kingdom is by no means a low tax country. In fact, its tax rates are almost as high as those of most European countries. Though lower income people are treated slightly better than in other places.

Income taxes on lower and middle income earners are moderate, the purchase of a first home is usually exempt from taxes in most regions of the UK, and VAT on food and other essential products and services is 0%. Higher earners do face very high taxes

On top of that, it should be mentioned that the country is moving in the wrong direction in terms of taxation, after having increased some tax rates, frozen many tax thresholds after double-digit inflation, and even lowered the threshold to pay some of the higher tax rates.

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And if you would like to learn about taxes in the neighbour country, check out the following analysis:
Taxes in Ireland – A Complete Guide

Taxes in the United Kingdom [2023] – A Complete Guide