The 60% Hidden Tax Rate

Did you know that if your earnings are between £100k to £125k you may be subject to an unofficial effective rate of income tax of 60%?  

Most UK taxpayers are entitled to receive the full tax free personal allowance of £12,570 as their earnings are likely to be below £100k. However, on income above £100k, there is an effective maximum tax rate of 62% (including 2% NI), whereby for every £2 of income over £100k you lose £1 of your tax-free personal allowance, (therefore up to £125,140 of income).

If your top rate of income sits within this threshold, there could be some appropriate tax planning measures to put in place to avoid this, for instance by limiting dividends from your own company or making pension contributions or Gift Aid charitable donations.  For every £2 of adjusted net income (taxable income less gross Gift Aid donations and personal pension contributions) received over £100,000, £1 of tax free personal allowance is lost.  So, for example, if your earnings are £105k, you lose £2.5k (50% of £5k in excess of £100k). The effective rate of tax between £100,000 and £125,140 therefore becomes 60%. 

The 60% comprises of the official 40% higher rate tax due on income between £100k and £125k plus a further 20% on the loss of the tax free personal allowance.  Once you earn over £125,140 you lose the full tax free personal allowance and the marginal income tax rate of 60% drops back to 45% (being the additional rate tax percentage for the 2023/24 tax year).

EXAMPLE: EARNINGS OF £125K

Jaime works as a Tax Partner advising high net worth individuals on wealth optimisation, tax efficient structuring and investment strategies.  In 2023/24 Jaime has earnings of £125k per year including a £25k bonus which is paid at the end of the tax year.  As Jaime earns £25k over £100k £12,500 of the tax personal allowance (£25k x 50%) will be lost leaving with only £70 remaining.  Therefore, Jaime will pay £5k (40% x £12,500) of extra taxable income in addition to £10k (40% x £25k) on £25k of income in excess of the £100k threshold.  The £25k in excess of £100k is therefore subject tax of £15k at the rate of 60%.  If Jaime made a net pension contribution of £20k then it would reduce adjusted net income to £100k and reinstate the full tax free personal allowance of £12,570. The basic rate band will be extended by 20% of the grossed up contributions or Gift Aid donation.  Tax relief on pension contributions exclude those made through salary sacrifice (tax relief is shown as a negative deduction on your payslip with relief already being obtained through the payroll), net pay arrangements (contributions are usually paid as a gross contribution and as a negative deduction from gross pay) or employer contributions (note that tax relief is not available on employer pension contributions).

 TAX PLANNING MEASURES: PENSION CONTRIBUTIONS

By making the pension contribution Jaime saved £20k in tax and the pension pot is now worth £25k.  The net cost to Jaime on retaining the PA is £10k comprising of a 20% £5k top up from the government, 20% £5k claimed through the Tax Return and a 20% £5k further saving from retaining the PA.  Making a pension contribution prevents exposure to 40% higher rate tax (by extension of the basic rate band) on the income excess of £100k plus an extra 40% on the loss of the £1 of £2 of the tax free personal allowance. This can counteract the fall in the 40% higher rate threshold.   You should initially try to increase workplace pension contributions but if this is not feasible you can make personal pension contributions. Tax relief available obtained on pension contributions depends if the contributions were made through a net pay arrangement or through relief at source.  Basic rate tax relief would be claimed on the pension contributions by the provider and if you are a higher rate taxpayer in the year the contributions are paid you would be entitled to claim a further tax relief at 20% on the gross contributions through your Tax Return or tax code.  Increasing personal contributions is a good way of ensuring that money is being set aside for the future. Of course, you must also ensure they have sufficient cash to make any pension contributions and/or charitable Gift Aid donations. Furthermore, pension statements will show the tax relief obtained.  You need a £1m pension pot to have pension income of £40k per annum so sooner you start saving the better.  To summarise, when Jaime receives all the pension income, the first 25% will be tax free with the balance taxable as non-savings income.

FLUCTUATIONS IN EARNINGS AND YOUR TAX CODE

You should be mindful if you are at risk of fluctuations in your earnings ie bonuses which are paid at the end of the year which push you into the £100k to £125k tax bracket. HMRC do not send us copies of PAYE codes and please would you therefore forward your future PAYE codes on to us to check as it may have an impact on your ongoing tax position, particularly if any changes are made. It is your responsibility as the taxpayer to ensure that you are on the correct tax code, not your employer or tax accountant.  Your employer will use a tax code provided by HMRC and will not necessarily see the breakdown the code or have the ability to change. Therefore, if an incorrect tax code is operated on your employment income this could result an under/over payment of tax when your Tax Return is eventually filed with HMRC. For example, if your earnings are £100k and you knew from the start of the tax year that you would receive a bonus in March which pushes you over £125k you should ensure a 0T tax code is operated from the start of the tax year to prevent an underpayment of tax.  For earnings between £100k to £125k it is not always easy to get the code precisely right.  From 6 April 2023 pension contributions and charitable donations under Gift Aid are particularly useful for tax planning if your earnings are just over the new additional rate threshold of £125,140.

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FUSE is an independent Chartered Certified firm of accountants and tax advisors based in Highgate Village, North London. We provide a dynamic range of services to clients working in property, media, entertainment and professional services. Our clients vary in size from self employed sole traders, small enterprises and medium size businesses. We believe that comprehensive financial planning and sound business financial advice are the keys to growth and profitability.