Surely this can’t be the case? Well it is. All Income tax tables will show that the highest income tax rate in the UK is 45% if you earn over £150,000, however a quirk in the system means if you earn over £100,000 you might start to pay an effective income tax rate of 60% on some of your earnings, putting it at the top of the table with certain areas of Sweden where they have both national and local income tax bands.
If you earn £100,000 gross income, your personal allowance (the amount of income you can earn without paying any income tax) reduces to nothing. The Institute of Fiscal Studies estimates that by the end of 2018/2019 as many as 800,000 people in the UK will be caught by this and many do not even realise. For every £2 someone earns over £100,000 their personal allowance of £11,850 reduces by £1, meaning if someone earns £123,700, they have no nil rate band.
Edward earns £123,700, so has no personal allowance. He pays tax as follows:
|Income in this Band||Tax Due|
|Personal Allowance @0%||£0||£0|
|Basic Rate Band||£34,500||£6,900|
|Higher Rate Band||£89,200||£35,680|
So £23,700 of earnings above £100,000 has been taxed as follows:
- 40% tax on the lost personal allowance (£11,850 x 40% = £4,740)
- 40% tax on the £23,700 which is within the higher rate band (23,700 x 40% = £9,480)
This part of Edward’s income is taxed at 60% – (£14,220 tax on £23,700 income).
A legitimate way of mitigating the impact of this hidden top rate of tax is to make a pension contribution.
Edward opts to pay a pension contribution of £18,960 net. He benefits from the basic rate tax relief in his pension, making it worth £23,700. His ‘adjusted net income’ will reduce from £123,700 to £100,000, reinstating his personal allowance of £11,850 and the basic rate band will grow by the gross contribution of £23,700. As a result of paying £18,960 into his pension Edward’s income tax will be calculated as follows:
|Income in this Band||Tax Due|
|Personal Allowance @0%||£11,850||£0|
|Basic Rate Band||£58,200||£11,640|
|Higher Rate Band||£53,650||£21,640|
Edward will pay £9,480 less in income tax, gain £4,740 within his pension and can complete a tax return and claim the higher rate tax relief on the pension contribution.
There are other ways to deflate taxable income, such as giving up salary in exchange for certain other benefits of an equivalent value such as the cycle to work scheme, childcare vouchers etc. You could also make a gift to a qualifying charity through Gift Aid which can also reduce taxable income.
Author: Phil James, Grosvenor Consultancy Ltd
There are advantages and disadvantages to using all of these strategies and they depend on individual circumstances so don’t take action without seeking competent advice. Tax rules, rates and allowances are all subject to change. The Financial Conduct Authority does not regulate tax advice and some forms of offshore investments. The value of investments and the income from them can fall as well as rise, you may not get back the full amount you invested and past performance is no guide to future performance.