Tax-free income

Not all income is taxable. Some is free of tax and so does not
have to be counted as part of your income when you work out
your tax.There are several types of tax-free income.

Some benefits are tax-free.They include:

• Most of the benefits paid for illness or disability such as Attendance Allowance, Disability Living Allowance, Severe Disablement Allowance, War Pensions and Industrial Injuries Benefits are tax free. Any extra allowances paid with these benefits are also tax-free. However, Incapacity Benefit is normally taxed, although the short-term Incapacity Benefit paid in the first 28 weeks of sickness is not taxable. A new Employment and Support Allowance begins in October 2008. Its tax status is not yet clear.
• Bereavement Payment (the £2,000 given to new widows, widowers and surviving civil partners who were under pension age when they were bereaved, or whose late partner was not receiving a State Retirement Pension).
• The £10 Christmas Bonus and the Winter Fuel Payment.
• Means-tested benefits such as Pension Credit, Council Tax Benefit, Housing Benefit, Working Tax Credit.
• Any benefits paid for children such as Child Benefit, Guardian's Allowance, extra allowances for children paid with a State Retirement Pension or any other benefit, and Child Tax Credit.

Generally prizes and winnings from gambling are tax-free,
including:

• your own profits from gambling on pools, racing, slot
  machines or bingo unless you gamble professionally
• Premium Bond prizes
• National Lottery prizes.

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Some types of investment income are free of tax including:

• the increase in value of National Savings Certificates, including Index-linked Certificates; and
• all the interest or profit earned on an Individual Savings Account (ISA) (though any dividends paid on shares have basic rate tax already deducted and you cannot reclaim it).

For more information on ISAs, and other investment options, see our free advice leaflet, Thinking About Money.

Finally, gifts from family or friends are normally free of income tax, even if they are given regularly as a form of income. A gift must be freely given with no obligation on you to do anything in exchange. However, if you are given an object rather than money, and it has grown in value since the donor got it, the donor may have to pay capital gains tax when they give it to you. And if you are given something very valuable or a lot of money, then inheritance tax may be due if the donor dies within seven years of making the gift.

If you need to find out more about inheritance tax or capital gains tax, your local HM Revenue & Customs Enquiry Centre or Citizens Advice Bureau may be able to help. You can find their contact details in your phone book.

Taxable income

Most income is taxable. This means that you have to pay tax on it if it is more than your tax-free allowance in the year. But, to do the calculation, you have to add your income up in three parts – interest on investments or savings, income from dividends, and all other income including pensions and earnings.

Interest on investments or savings

Interest on investments or savings is normally taxable – apart from the interest earned on the tax-free investments described earlier. Interest can be paid in two ways.

- Gross interest

Some interest is paid without tax being deducted from it – that is called being paid 'gross'. But you still have to pay tax on it. Interest paid gross includes:

• Interest paid on Government stock which are also called ‘gilts’, though if you want you can choose to have gilts paid net of basic rate tax
• the ‘dividends’ earned on any money you have saved with a credit union. These are investment income and are not treated like dividends on shares
• interest paid on savings accounts which are held offshore in another country. However, the country where the account is located may deduct some tax from the interest. Alternatively it may ask you for permission to inform HM Revenue & Customs about your offshore account.

- Net interest

Most interest is paid with tax already deducted at 20 per cent. This is called being paid ‘net of basic rate tax'. To work out your tax, you need to use the amount of the income before tax is deducted. You can find this figure in the statement or pass book from your bank or building society. Alternatively, you can work it out by taking the interest net of tax then dividing by four and multiplying by five. This is called 'grossing up'.
  
If your income is low enough so that you pay no tax then you can claim back the tax which has been automatically deducted from your interest on investments or savings. You can claim back all of it if you pay no tax or half of it if you only pay tax on your savings interest at the lower rate of 10p in the pound – see section 4 for the details of how that works and see section 7 for details of how to claim the tax back.

Add up any interest on investments or savings you expect to get between 6 April 2008–5 April 2009. Use the grossed up amount. Write the answer in the interest on investments or savings box on the calculations sheet.

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Income from dividends

Dividends paid on any shares you own are taxed differently from other investment income. Tax is already deducted from the dividends before you get the money. That means there is no further tax to pay on them unless you pay tax at the higher rate. But if your income is too low to pay tax you can no longer reclaim the tax that has already been paid.

Add up any income you expect to get from dividends between 6 April 2008 and 5 April 2009. Divide the amount by nine and multiply by ten to work out your dividend income before tax. Write the answer in the income from dividends box on the calculations sheet. You won’t need it for your tax calculation but you may need it to work out your tax allowances if your income is more than £21,800.

Other income including pensions and benefits

Most other income is taxable.This includes:

• An occupational, personal or stakeholder pension including retirement annuity contracts – also known as s.226 pensions. It will usually have tax deducted from it by the organisation which pays you. When you come to add up your income to work out your tax, use the figure before tax is deducted. You will find that figure on the payment document.
• All parts of the State Retirement Pension. A married woman’s pension based on her husband’s contributions is counted as her income when tax is worked out. However, if she is under 60, and her husband gets extra pension for her as a dependant, then that amount is counted as his income.

Other taxable benefits:

• Bereavement Allowance
• Jobseeker’s Allowance
• Carer’s Allowance
• any extra amount you get with these benefits for
  a dependent wife, husband or civil partner
• Statutory Sick Pay
• Incapacity benefit paid after the first 28 weeks of sickness is usually taxable.

Add up all the taxable income, including pensions and earnings, you expect to get between 6 April 2008 and 5 April 2009. Write it down in the other income including pensions and earnings box on the calculations sheet.