Income Tax: What It Is and How It Works
Income tax is a tax charged on income earned by individuals and, in some cases, entities—depending on how the business is structured. Income tax generally applies to earnings such as wages, self-employment profits, rental income, investment income, and certain other income sources. The exact rates, bands, reliefs, and filing requirements vary by jurisdiction.
At a high level, income tax systems typically involve:
- Defining what counts as taxable income
- Allowing certain deductions or reliefs
- Applying tax rates (often progressive, with bands)
- Collecting tax through withholding and/or self-assessment
How income tax is collected
Many systems collect income tax in two main ways:
1) Withholding at source
Employers deduct tax from wages before paying employees. This is designed to spread tax payments throughout the year and reduce end-of-year balances.
2) Self-assessment / annual returns
Individuals (especially self-employed people and those with multiple income sources) report income and calculate tax due through a tax return process, paying any balance after withholding.
What affects how much income tax you pay?
Income tax is influenced by:
- Total income across all sources
- Allowances, deductions, and reliefs available
- Tax bands/rates that apply to different portions of income
- Filing status and residency rules (depending on country)
- Other related charges that may sit alongside income tax
From a business perspective, income tax matters most in:
- Payroll planning (employee tax withholding)
- Owner remuneration strategy (salary vs distributions)
- Budgeting for self-employed tax payments
- Recording tax deductions correctly and on time
In the UK and Ireland, employment income is typically taxed through PAYE-style withholding, and self-employed individuals commonly pay via return-based systems—so accurate payroll and year-end reporting are crucial.
Is income tax the same as corporation tax?
No. Income tax applies mainly to individuals’ income. Corporation tax applies to company profits (where relevant). Owners may still pay income tax on money they personally receive.
Do self-employed people pay income tax differently?
Often yes. They typically calculate taxable profit and pay income tax through an annual return process, sometimes with payments on account or preliminary payments depending on the system.
What records should I keep for income tax?
Common records include payslips, invoices, expense receipts, bank statements, mileage logs (if relevant), and documentation supporting deductions or reliefs.
