How Tax Returns Are Calculated

In my experience, one of the most common questions I get is, “How are tax returns calculated?” It’s easy to feel lost when trying to understand how HMRC determines how much tax you owe (or how much you’re due back). In this blog, I’ll break down the basic steps and factors that go into calculating tax returns in the UK, so you can understand exactly how your tax liability is worked out and how to ensure it’s accurate.

1. Starting with Your Total Income

Assessing All Income Sources

When calculating a tax return, the first step is to assess all your sources of income. This includes not just your salary or earnings from self-employment, but also rental income, dividends from investments, and any interest from savings accounts. All income needs to be added up before any deductions or reliefs can be applied.

For most of my clients, organizing income documents—like payslips, bank statements, and invoices—right from the start of the tax year helps ensure nothing is overlooked.

Understanding Tax-Free Allowances

In the UK, there are specific tax-free allowances, which reduce the portion of your income that’s subject to tax. The personal allowance, for example, allows you to earn up to £12,570 tax-free (as of the 2023/24 tax year). Certain other allowances, such as the savings allowance and dividend allowance, apply to interest and dividends, respectively. I always remind clients that allowances can differ depending on your total income, so it’s key to check your exact entitlements. This is key to remember for how tax returns are calculated.

2. Applying the Relevant Tax Bands

Income Tax Rates

Once your total taxable income is calculated, HMRC applies tax bands to determine the tax rate. In England, there are three main income tax bands:

• Basic Rate (20%): Applies to earnings between £12,571 and £50,270.
• Higher Rate (40%): Applies to income between £50,271 and £125,140.
• Additional Rate (45%): For income over £125,140.

For those with multiple income sources, especially high earners, knowing these bands is essential as it directly affects the tax owed. I often help clients calculate which portion of their income falls into each band, as these calculations can get tricky when different income types are taxed differently.

National Insurance Contributions

In addition to income tax, individuals also pay National Insurance (NI) contributions, depending on their employment status and income level. National Insurance helps fund public benefits, including healthcare and state pensions. Self-employed individuals and employees have different NI classes, so calculating this accurately is a key part of determining your overall tax bill.

3. Calculating Deductions and Reliefs

Business Expenses

For self-employed individuals, claiming allowable business expenses is crucial. Business expenses reduce taxable income, which in turn reduces the tax owed. Examples of common allowable expenses include office supplies, travel costs, and utilities (if you work from home). From my experience, thorough record-keeping throughout the year makes it much easier to accurately claim expenses at the end of the tax year.

Tax Reliefs on Contributions

Certain contributions, such as to pension schemes or charitable donations, qualify for tax relief, meaning they lower your taxable income. Higher-rate taxpayers can especially benefit from these reliefs, as they effectively reduce the portion of income taxed at 40% or 45%. Many clients find tax relief a bit confusing, so I often help by calculating the eligible reliefs they can claim based on their contributions.

4. Adding Capital Gains and Dividend Tax, If Applicable

Capital Gains Tax (CGT)

If you’ve sold assets like property or shares, any profit made over the annual CGT allowance may be subject to capital gains tax. Different assets have different CGT rates, and the rate applied depends on your income tax band. Understanding how to calculate capital gains and when to include them on your tax return is essential, as this can impact your overall tax liability significantly.

Dividend Income

For those receiving dividends from investments, there’s a specific dividend allowance (currently £1,000 for the 2023/24 tax year). Any dividend income over this allowance is taxed at rates based on your income tax band. Clients often benefit from a review of their investment income, as it ensures all allowable reliefs and allowances are applied correctly.

5. Final Calculation and Balancing Payments

Calculating Your Final Tax Bill

After taking total income, applying the relevant tax bands, and accounting for all deductions and reliefs, we arrive at your final tax liability. This amount is what you owe HMRC for the tax year. If your self-assessment shows you’ve overpaid, HMRC will issue a refund. If you owe additional tax, payment is due by the 31st January following the end of the tax year.

Payments on Account

For those with a tax bill over £1,000, HMRC may require payments on account. These are advance payments toward the next tax year’s bill, split between 31st January and 31st July. I advise clients to plan for these payments, as they help avoid a large tax bill the following year.

Common Mistakes and Tips for Accurate Tax Calculation

Avoiding Overlooked Deductions

It’s easy to miss out on tax savings if deductions aren’t properly calculated. Double-checking that all eligible expenses and reliefs are claimed can make a big difference. I also suggest creating a simple spreadsheet to track expenses throughout the year for easy reference at tax time.

Staying Informed of Allowance Changes

HMRC often revises tax allowances and bands annually. Staying informed about these changes helps ensure that your tax return accurately reflects current rules. If you’re unsure, it’s always wise to consult a professional to avoid any errors in calculations.

How TRW Accountants Can Help

At TRW Accountants, I specialise in guiding clients through the tax calculation process, ensuring that every allowance, relief, and deduction is applied correctly. Our comprehensive support makes tax filing straightforward, whether you’re managing self-employment income, investments, or property gains. Contact us today to see how we can simplify your tax return and ensure accuracy in your calculations.

Conclusion

Understanding how tax returns are calculated involves several key steps, from adding up income sources and applying tax bands to claiming deductions and reliefs. By staying organised, keeping accurate records, and planning for payments, you can avoid unnecessary stress and ensure your tax return reflects your financial situation accurately. And if you’d rather not tackle it alone, professional guidance is always available to make the process smoother.

For more insights, check out our resources on How Do Accountants Do Tax Returns? and Are tax returns done alphabetically?