Understanding Business Accounting For Dummies, 2nd Edition (27 page)

Taxable Income:
The first £9,005 of income earned by the example in the basic income tax model shown is
not
subject to income tax - equal to the personal exemption of £5,405 plus deduction of £3,600 for contributions to a stakeholder pension. Income above this amount is taxable. The taxable income in this example is £53,695 because the £9,005 of income is offset by allowances and deductions. You multiply the taxable income by the tax rates - one rate for the first layer of taxable income and a higher rate for the next layer - to determine the income tax amount.

Tax Rates:
UK income tax is based on the
progressive taxation
philosophy - as your income progresses, your tax rate progresses. Taxable income is subdivided into
brackets
or
layers;
each higher one is subject to a higher income tax rate. The lowest rate is 20 per cent; the top rate is 40 per cent on taxable income in excess of £35,800. The brackets and rates can change from year to year, but don't worry - the Chancellor keeps you informed in the booklet that comes with your annual income tax forms.

Income Tax Amount:
In 2008, the tax rate on £53,695 taxable income was 20 per cent on the first £35,800. The rate then doubles to 40 per cent on all further income. As you can see in the example, the income tax on the £53,695 taxable income is £14,318.

In this example, the income tax of £14,318 is 26.67 per cent of the £53,695 taxable income and 22.84 per cent of the £62,700 gross income. However, the
marginal tax rate
gets the most attention. The marginal tax rate is the rate that applies to the margin, or highest layer of taxable income. The margin in this example is the taxable income in excess of £35,800. For each additional £1,000 of income over this amount, the person in this example pays £400 of income tax. They are in the 40 per cent marginal income tax bracket.

The marginal tax rate starts at 20 per cent on the first pound of
taxable
income. Remember that you do not have any taxable income until your annual income exceeds the total of your personal exemptions plus the standard deduction. In this example, the first £9,005 of income is not taxable because the total of personal allowances and deduction equals this amount. The remainder is taxed at 40 per cent.

We find that using a
marginal
income tax rate of 33 per cent is generally accurate and computationally convenient. This number may be too high or too low for a specific individual or married couple, but it's reasonably accurate for a broad range of taxpayers. (If you're a multimillionaire, you probably should shift up to a 39.5 per cent marginal tax rate.) In other words, most of the readers of this book can assume that if they receive a £1,000 raise, about 33 per cent of that will be lost to taxes. Or, if you'd like to buy a new pair of trainers that cost £67 at the sports shop, you need £100 of income before taxes to have £67 left over, after taxes, for the shoes.

The Ins and Outs of Figuring Interest and Return on Investment (ROI)

In addition to understanding the basic model of income tax accounting, you should have a good grip on the calculation of periodic interest and how return on investment is measured. Interest rates and return on investment (ROI) rates are tossed around freely as if everyone were intimately familiar with how these important ratios are calculated. In fact, many people do not understand these key accounting calculations. In our experience, most people get sweaty palms when they have to think about how interest is actually calculated and how investment performance is measured. The following sections should reduce your anxiety about these matters, which have a big impact on your personal financial affairs.

Individuals as borrowers

Everyone borrows money - as car loans, as mortgages, as unpaid credit card balances and so on. When you borrow money, you agree to a method of interest accounting, whether you understand the method or not. You should be clear on the following points:

If you make more than one loan payment per year, divide the annual interest rate by the number of loan payments to determine the interest rate per period, which usually is a month or a quarter. In other words, the quoted annual rate is simply the number to divide into to get the real interest rate per month or per quarter.

When you make two or more loan payments, each payment goes first to the interest amount; the remainder is deducted from the loan balance, called the
capital.
The amount of the capital repaid each period is referred to as the
amortisation
of the loan. The total amount borrowed has to be amortised, or paid back to the lender, over the life of the loan.

Shortening the term of a very long-term loan, say from 30 years to 15 years, results in a dramatic decrease in the total interest paid over the life of the loan, but a relatively small increase in the monthly loan payment amount.

A monthly interest rate should not be multiplied by 12 to determine the
effective annual interest rate
; likewise, a quarterly interest rate should not be multiplied by 4 to determine the effective annual interest rate. Annual effective rates assume the
compounding
of interest during the year. Compounding means paying interest on interest; it is an extremely important building block for understanding financial matters.