How Does Paying Taxes Actually Work? A Beginner’s Guide

Taxes are paid on your income or profits, either automatically through your employer or by filing an official document (a tax return) annually.

The amount you pay depends on your income, allowances, expenses, and the types of taxes that apply.

Once you understand how tax is calculated, collected, and distributed, the system becomes much easier to navigate.

So if you want to learn how paying taxes works in practice, keep on reading.

Key points

• Paying taxes follows a simple process 💷
  Paying taxes generally includes six steps: earn income, track it, report it, calculate what you owe, pay it, and stay on top of deadlines. Once you understand that flow, the tax system feels much less intimidating.
• You usually pay tax on profit or taxable income, not everything you receive 📊
  This is especially important if you’re self employed. Allowable expenses can reduce taxable profit, and progressive tax bands mean that higher rates apply only to portions of income above certain thresholds.
• Good habits help you avoid common tax problems 📅
  Keeping records updated, reviewing your finances regularly, and setting aside money for tax can help you avoid unexpected bills, missed deadlines, or incorrect payments to HMRC.
• Making Tax Digital is changing how tax is managed 💻
  With digital record-keeping and more frequent reporting becoming the norm, tax is moving away from a once-a-year task and towards something managed throughout the year.
• Using the right tools can make paying tax much easier 🚀
  Instead of managing income, expenses, deadlines, and HMRC reporting manually, tools like ANNA can automate much of the process, estimate your taxes in real time, and even help you set money aside as you earn. For many self employed people, that can make staying on top of tax far simpler.

What are taxes, really?

Taxes are mandatory payments you make to the government to fund public services, such as healthcare, education, infrastructure, and welfare.

In the UK, the main taxes are:

• Income Tax: This is the tax that you pay on your earnings
• National Insurance: These are contributions that help fund benefits and pensions
• VAT: This tax is applied to most goods and services (usually handled by businesses)

If you’re employed, much of this happens automatically. If you’re self employed or running a business, you’re more directly responsible for managing and paying your taxes.

How does paying taxes work? A step-by-step breakdown

At the most basic level, paying tax usually follows a simple process:

Step 1: Earning money

Everything starts with income.

This could come from:

• A salary (employment)
• Freelance or contract work
• Business profits
• Investments or property

It’s worth mentioning that everyone has what’s called a Personal Allowance, which is the amount you can earn each year tax-free. In the UK, the Personal Allowance limit is £12,570. Anything above that is subject to Income Tax.

Step 2: Tracking what you earn and spend

Before you can pay tax, you need to know how much you’ve made.

If you’re employed, your employer tracks this for you through payroll.

If you’re self employed, you need to keep records of all income received and all allowable expenses, such as business supplies, travel, or software costs.

Expenses matter because they reduce your taxable profit. For example, if you earn £30,000 but spend £5,000 on business costs, you’re only taxed on £25,000.

Good record-keeping is essential here. Without it, you risk overpaying or underpaying tax.

Step 3: Reporting your income

Once you know your numbers, you need to report them.

Option A: If you’re employed

Your employer handles this through the PAYE (Pay As You Earn) system. Tax and National Insurance are deducted automatically from your salary before you’re paid.

Option B: If you’re self employed

You report your income through a Self Assessment tax return.

This is where you declare your total income, expenses, and profit. You submit this to HMRC once a year.

Step 4: Calculating how much tax you owe

After reporting your income, the next step is calculating your tax bill.

This depends on your income, your income type, and current tax rates and thresholds.

The UK uses a progressive tax system, which means you pay different rates on different portions of your income – higher rates apply only to the portion of income above each threshold.

It works like this:

• Up to £12,570 of your income is tax-free
• The next portion, from £12,571–£50,270, is taxed at a basic rate of 20%
• The higher portion, from £50,271–£125,140, is taxed at the higher rate of 40%
• If you have over £125,140 in income, it’ll be taxed at the additional rate of 45%

If you’re employed, this calculation is done automatically.

If you’re self employed, HMRC calculates it after you submit your return, though it’s wise to estimate it in advance so you’re prepared.

Step 5: Paying your tax bill

Once your tax is calculated, you need to pay it.

If you’re employed, your taxes are handled automatically by your employer through PAYE.

If you’re self employed, you usually pay by 31 January following the end of the tax year. You could also make payments on account, which are advance payments towards your next bill.

This often means your first tax bill can be larger than expected, because it may include both current tax and an advance payment toward the next year.

Step 6: Staying aware of deadlines and the tax year

The UK tax year runs from 6 April to 5 April the following year.

Key deadlines include:

• 5 October: Register for Self Assessment (if newly self employed)
• 31 January: Submit your online tax return and pay your bill
• 31 July: Pay your second payment on account (if applicable)

Missing deadlines can lead to penalties, even if you don’t owe much tax.

What happens if you pay too much or too little tax?

If you pay too much tax, you may be able to get a refund. If you pay too little tax, you may need to repay the difference to HMRC.

This can happen due to tax code errors, income changes, reporting mistakes, or missing information.

If you pay too much tax

Overpaying tax can happen for several reasons, including:

• Being put on an emergency tax code
• Changing jobs during the year
• Starting or leaving a job mid-year
• Having the wrong tax code
• Not claiming allowances or reliefs you’re entitled to

In some cases, HMRC may correct this automatically and issue a refund. In others, you may need to claim the overpaid tax back.

Tip: Check your payslips and tax code regularly, especially after changing jobs or income sources. Small errors can lead to overpaying for months before you notice.

If you’re self employed, keeping accurate records and claiming allowable expenses properly can also help prevent overpaying.

If you pay too little tax

Underpaying can happen, too.

Common reasons include:

• Income being underreported
• The wrong tax code
• Missing income from side work or investments
• Errors on a tax return

If you have underpaid, HMRC will usually contact you about what is owed and how it will be collected.

For employees, underpaid tax may sometimes be recovered through adjustments to your tax code. For self employed people, it may mean paying the difference directly.

Tip: If you’re self employed, estimating your tax bill throughout the year can help avoid unpleasant surprises at deadline time.

The key thing to remember is that mistakes can often be corrected. Spotting issues early usually makes resolving them much easier.

How Making Tax Digital for Income Tax changes the process

Making Tax Digital for Income Tax (MTD for ITSA) is gradually changing how taxes are reported and paid in the UK. Instead of one annual submission, the system is moving towards more frequent, digital updates.

The goal is simple: make taxes more accurate, more transparent, and less of a last-minute rush.

In practice, it changes several key steps in the process:

Record-keeping becomes fully digital

Under MTD, keeping digital records is a requirement.

You’ll need to:

• Keep digital records of income and expenses
• Use MTD-compatible software
• Avoid manual processes like spreadsheets that aren’t linked to submissions

This means no more scrambling through receipts at the end of the year. Your records need to be continuously up to date.

Reporting becomes more frequent

This is one of the biggest shifts.

Instead of submitting a single Self Assessment tax return once a year, MTD requires:

• Quarterly updates to HMRC
• A final end-of-period statement to confirm your figures

That means you’ll report your income and expenses throughout the year, not just in January.

Keep in mind that these quarterly updates aren’t full tax returns. They’re snapshots of your business activity.

Tax estimates become more visible

Because you’re submitting data throughout the year, HMRC can build a clearer picture of your tax position earlier.

This means:

• You’ll get ongoing estimates of what you owe
• You’re less likely to face a surprise bill at the end of the year

This approach makes budgeting and financial planning much simpler.

Paying tax becomes easier to manage

MTD doesn’t fully change when tax is due, but it opens the door to more frequent payment habits.

Instead of paying a large lump sum in January, many people will move towards:

• Setting aside money regularly
• Making voluntary payments throughout the year

This isn’t mandatory, but it becomes the natural way to manage tax when you have real-time visibility of your liabilities.

How to build good tax habits early

Good tax habits can make managing your finances much more straightforward and help you avoid stress later on. Often, tax problems arise not from misunderstanding the rules, but from putting admin off until it’s too late.

Here are some ways to avoid tax problems:

Update your records weekly or monthly

Don’t wait until tax return season to sort through receipts and transactions. Updating your records regularly makes it easier to track income, claim allowable expenses, and spot mistakes early.

Use software that connects directly to HMRC

Digital tax software can reduce manual work and help you stay organised. Many tools can track income and expenses, estimate taxes, and help keep you ready for filing deadlines.

Review your income and expenses regularly

Checking in on your finances helps you understand how much profit you are making and whether your likely tax bill is changing.

Regular reviews can also help you plan ahead, rather than being surprised by what you owe.

Set aside tax as you earn

If tax isn’t deducted automatically, it’s easy to treat all income as available to spend.

A good habit is putting aside money for taxes every time you get paid, so the money is there when deadlines arrive.

The earlier you build these habits, the easier tax becomes. Good systems don’t have to be complicated – consistency matters far more.

Simplify taxes for free with ANNA

For many self employed people, the challenge isn’t understanding what you need to do – it’s doing everything consistently while running a business. Records fall behind, tax bills catch people off guard, and deadlines become stressful.

Instead of managing all of this manually, ANNA helps make paying taxes feel far less hands-on by doing much of the work in the background.

With ANNA, you get:

• Real-time tax estimates: See how much tax you may owe as you earn, instead of waiting until January to find out.
• Automatic expense tracking and bookkeeping: Know your profit as you go, not months later when it’s time to file.
• Smart pots for setting tax aside: Put money aside automatically for tax, so bills and Payments on Account are easier to manage.
• Built-in support for Self Assessment and MTD: Stay organised for annual filing now, while getting ready for quarterly digital reporting under MTD.
• A business account, invoicing, and tax admin in one place: No separate tools, no complicated setup, and no juggling banking and bookkeeping.
• 24/7 support when you need it: Have any questions about tax, filing, or HMRC? Help is there when you need it.

And if you register with ANNA now, you’ll get your 2025/26 Self Assessment filed for free. If you’re already registered with someone else, ANNA will refund the filing fee when you switch.

If you want to stay on top of taxes from day one, with far less admin, register with ANNA today.