Most UK taxpayers are entitled to a part of their income tax—free, i.e. a personal allowance. The personal allowance for 2017/18 is £11,500.
By contrast, individuals with annual income exceeding £100,000 lose £1 of their personal allowance for every £2 of income above £100,000. The higher rate threshold at which tax is charged at 40% also falls in step with the personal allowance, meaning that not only are you taxed at 40% on the additional £1, you also pay an extra 20% per £1 lost, resulting in the marginal rate of 60%.
This continues up to £123,000 (£100,000 plus £11,500 x 2), at which point your entire personal allowance has been lost and the marginal Income Tax rate drops back to 40%.
To provide an example, take Mike, an individual with total income of £120,000 in 2017/18. He loses £10,000 of his personal allowance, leaving only £1,500. This £10,000 of extra taxable income (at 40%) gives £4,000 more Income Tax on top of the £8,000 due on the £20,000 income over and above the £100,000 threshold. Therefore, £12,000 Income Tax as a result of the extra £20,000 income is an effective rate of 60%.
Those at particular risk are normally earners in receipt of variable employment bonuses which are paid toward the end of the tax year and may push their total annual income above £100,000 or traders with fluctuating profits. Clearly, the 60% rate is a punitive result, but there are some tax-efficient strategies available to alleviate it.
The first is to make personal pension contributions (including contributions to SIPPs but excluding those paid under salary sacrifice or employer contributions). Pension contributions are treated as being paid net of basic rate tax and increase the basic rate band by 20% of the grossed-up amount. This can serve to counteract the fall in the higher rate threshold triggered by the loss of the personal allowance.
The second solution is to make charitable donations under Gift Aid. These are treated in a comparable way to pension contributions whereby the basic rate band is extended by 20% of the grossed up contributions.
However, both of these require cash, so you need to be fully aware of the consequences.
This article was taken from the Spring 2018 issue of the Private Client team's Quarterly Tax Digest. You can access all the other articles here.
If you anticipate that your total annual income will be in excess of £100,000 but below £123,000, please approach your usual Buzzacott contact or complete the form below.