The top rate of income tax is 45% – on paper at least! However, a quirk in the tax system means some high earners could be paying tax at an effective rate of 60%. The good news is that with careful planning, it may be possible to minimise your exposure to the ‘hidden’ top rate.
The tax system explained
Income tax is payable on earnings in excess of the personal allowance (PA), which is £11,500 for 2017/18. Earnings between £11,501 and £45,000 (£43,000 for Scottish taxpayers) are then taxed at the basic rate of 20%, while earnings between £45,001 (£43,001 in Scotland) and £150,000 are subject to higher rate tax of 40%. Earnings in excess of £150,000 are taxed at the additional rate of 45%. (There are some variations from the above rates for savings income which are not considered here.)
However, for some higher earners, the situation is not as straightforward as it might first appear. This is because the PA is scaled back for individuals with adjusted net income over £100,000. Adjusted net income is broadly taxable income less pension contributions and gift aid donations, grossed up to include any tax relief due.
The PA is reduced by £1 for every £2 of income in excess of this limit, meaning that someone with adjusted income of £123,000 or more in 2017/18 will not be entitled to any PA. For every additional £2 of income there will be a tax charge at 40%, plus a further £1 of income will become taxable at 40%. This has the effect of adding an extra 20% of tax on income between £100,000 and £123,000, giving an effective tax rate on this slice of income of 60%!
Although the government does not officially recognise the 60% marginal rate, the Institute for Fiscal Studies predicts that it will apply to at least 800,000 people this year, rising to one million by the end of 2018/19.
Minimising your liability
Wherever possible, individuals should consider what steps they can legitimately take to mitigate the impact of the ‘hidden’ top rate. This might involve strategies to reduce taxable income to below the level at which the 60% rate bites, but please do seek our advice before taking action.
Increase pension contributions
Increasing contributions to a registered pension scheme can help to reduce adjusted net income to £100,000, thereby preserving an individual’s entitlement to the PA. Even if the PA is not fully preserved, any personal contributions to a pension normally qualify for tax relief at the individual’s marginal rate of tax, which in this case is 60%!
The rules on pension contributions are complex and various restrictions apply.
Make Gift Aid donations
Making donations to a qualifying charity through Gift Aid can also reduce taxable income in the same way as making pension contributions.
Consider a salary sacrifice arrangement
Salary sacrifice allows employees to exchange a portion of their cash pay in return for non-cash benefits-in-kind. For those with income over £100,000, giving up a portion of their salary may help to lower their taxable income if the benefit received is non-taxable or valued at less than the salary foregone for tax purposes. This in turn will lessen the impact of the 60% tax rate.
Although the tax advantages of some types of salary sacrifice schemes were removed in April 2017, certain benefits have escaped the changes. These include childcare vouchers, Cycle-to-Work schemes and ultra-low emission cars with CO2 emissions of up to 75 g/km. (Note that individuals wanting to apply for childcare vouchers will need to do so before April 2018, when the scheme closes to new entrants.)
For further advice on minimising the impact of the 60% tax rate, please get in touch.