Are you paying 60% tax on part of your income?
It’s a common misconception that the highest rate of effective income tax one can pay is 45%. In fact, due to a quirk in the tax rules, there are two scenarios where individuals are effectively paying up to 60% on part of their earnings. It’s affecting more and more people, with data from the Institute for Fiscal Studies showing that 800,000 people will be caught this financial year – up from 588,000 in 2010-11¹.
However, there are actions you can take to help mitigate some of this penal tax. Our Wealth Adviser, Sagar Morjaria, explores the scenarios and provides our top tips if you are caught by them.
The 60% income tax ‘personal allowance trap’
Each year you have a ‘personal allowance’ which is free of income tax. If you earn £100,000 pa or less, you could be entitled to the full personal allowance of £11,850 and your income tax position could look like this:
However, under rules announced in 2010, your personal allowance reduces by £1 for every £2 you earn above £100,000. If you earn £123,700 or more, you’ll lose your personal allowance altogether. And somewhere in between £100,000 and £123,700 you could find yourself in the 60% trap.
To illustrate this, if you earn £110,000 pa your position could look like this:
The extra £10,000 salary means that:
- The £10,000 is taxed at 40% - an extra £4,000 tax
- You also lose £5,000 of your personal allowance due to the £1 reduction for every £2 of extra salary over £100,000; this would also now be taxed at 40% - an additional tax of £2,000.
The extra tax would be £6,000 for £10,000 extra earnings – a rate of 60%.
The child benefit income tax trap
If you get child benefits, you could face a ‘high income child benefit tax charge’ of 1% for each £100 you earn above £50,000, so the benefit is cancelled out by the time you earn £60,000.
If you have two children and each parent earns less than £50,000 a year, you’d receive approximately £1,790 in child benefits.
However, if one of you received a pay rise of £5,000, you would lose £895 in child benefit, since you incur a ‘high income child benefit tax charge’ of 50%. Because your salary is in the higher rate tax band of 40%, the £5,000 would be taxed at 40% = £2,000. So, your £5,000 pay rise would effectively cost you £2,895 – a tax of almost 58%.
Our top tips if you are caught by these income tax traps
- Reinstate your personal allowance by contributing more into a pension
The level of income used for assessing how much personal allowance or child benefit you are entitled to is calculated after deducting the gross amount of any pension contributions you have made in that tax year. So, if your earnings were £110,000 pa and you decided to contribute £10,000 (gross) into a pension, you would reinstate your personal allowance and you’d be £6,000 better off².
2. Reduce your cash pay from your employer
This arrangement, known as salary sacrifice, has the advantage of reducing both the income tax you pay and the national insurance you and your employer may pay. Simply reducing your take-home pay through salary sacrifice could work to reinstate your personal allowance or child benefits.
3.Make gifts to charities under Gift Aid rules
This can have a similar effect. What is more, these could be backdated to the previous year, so long as the donation is made before the tax return for that year is filled.
2 This includes your pension tax reliefs.
If you’d like to find out more about income tax and how you can avoid the traps, get in touch with Sagar Morjaria here.
The tax treatments set out in this communication are based on our current understanding of UK legislation. It is a broad summary and cannot cover every circumstance and it does not constitute advice.
Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
The information contained herein is based on materials and sources that we believe to be reliable, however, Canaccord Genuity Wealth Management makes no representation or warranty, either expressed or implied, in relation to the accuracy, completeness or reliability of the information contained herein. All opinions and estimates included in this document are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information contained herein.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.