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Avoiding marginal rates of income tax

By Sarah Laing, November 2019

Sarah Laing examines circumstances where individuals could be paying effective income tax rates of up to 60%. 

When people are asked how many income tax rates there are in the UK tax system (for 2019/20), the majority are likely to opt for three (i.e. a 20% basic rate, 40% higher rate and 45% additional rate).  

Effective tax rates 

However, there are also ‘effective’ rates of tax that an individual might suffer on parts of their income.

The personal tax allowance (for 2019/20) is £12,500 and this is subject to a single income limit of £100,000. Where an individual’s ‘adjusted net income’ is below or equal to the £100,000 limit, they continue to be entitled to the full amount of the basic personal allowance.

However, if ‘adjusted net income’ exceeds the £100,000 limit, the personal allowance is reduced by £1 for every £2 above the income limit. The personal allowance may be reduced to nil from this income limit. Broadly, ‘adjusted net income’ is total taxable income before any personal allowances, less certain tax reliefs (including trading losses, gift aid donations, and pension contributions).

As a consequence of the personal allowance abatement, taxpayers with income between £100,000 and approximately £125,000 will suffer marginal tax rates of up to 60% as the personal allowance is withdrawn, where income is above a higher rate threshold of £100,000.  

Example: Expensive bonus 

Bert earns a salary of £100,000 from employment and has no other sources of income. He is paid a bonus of £7,000. He is entitled to a personal tax allowance of £12,500 in 2019/20, but he loses £3,500 of it (i.e. £1 for every £2 earned over £100,000: (£107,000 – £100,000)/2), leaving him with an allowance of £9,000. He will pay tax of £2,800 (i.e. £7,000 × 40%) on the bonus, plus an extra £1,400 due to lost allowances (i.e. £3,500 × 40%). His total tax attributable to the bonus is therefore £4,200.

Bert pays an effective rate of tax of 60% on his bonus income (i.e. £4,200/£7,000 x 100).

Contrast this with Charlie, who earns a salary of £125,000 from employment and also has no other sources of income. Charlie is also paid a bonus of £7,000. He is entitled to a personal tax allowance of £12,500 in 2019/20, but he loses entitlement to all of it because his basic salary exceeds the point at which the allowance is fully withdrawn (i.e. £125,000). Receiving the bonus, therefore, results in no further adjustment to his personal allowance. He will simply pay tax of £2,800 (i.e. £7,000 × 40%) on the bonus, which means that his effective tax rate on that part of his income is only 40%.

Other areas where problems can arise with marginal tax rates include where tax credits are being claimed by individuals with income levels around the abatement threshold; and where dividend or savings income just nudges a taxpayer’s income into the higher rate tax bracket. 

Avoiding the rates 

Individuals with income slightly exceeding the £100,000 ceiling may avoid losing some or all of their personal allowance by taking steps to reduce ‘adjusted net income’ to below the abatement threshold. Options worth considering may include: 

  • transferring income-producing assets to a lower-earning spouse or civil partner; 
  • increasing pension contributions. For example, a taxpayer with income of £105,000 might consider making a pension contribution of £5,000. They will get 40% tax relief on the contribution, and the full personal allowance will be reinstated; 
  • making donations to charity under the gift aid scheme. For the charity, the donation is assumed to be made net of basic rate tax, which the charity claims back from HMRC. For the taxpayer, their basic rate tax band is increased by the value of the gross donation. 

Practical Tip 

As with all tax planning opportunities, the wider picture should be considered before taking any action. In particular, the benefits of any tax saving need to outweigh the cost and administrative inconvenience of the transaction. 

 

Sarah Laing examines circumstances where individuals could be paying effective income tax rates of up to 60%. 

When people are asked how many income tax rates there are in the UK tax system (for 2019/20), the majority are likely to opt for three (i.e. a 20% basic rate, 40% higher rate and 45% additional rate).  

Effective tax rates 

However, there are also ‘effective’ rates of tax that an individual might suffer on parts of their income.

The personal tax allowance (for 2019/20) is £12,500 and this is subject to a single income limit of £100,000. Where an individual’s ‘adjusted net income’ is below or equal to the £100,000 limit, they continue to be entitled to the full amount of the basic personal allowance.

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