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The personal allowance trap
For 2012-13 the personal allowance of £8,105 is gradually reduced to nil where a person's income exceeds £100,000. The reduction is £1 for every £2 that income exceeds the threshold. Therefore, a person with income of £116,210 or more is not entitled to any personal allowance (£116,210 – £100,000 = £16,210/2 = £8,105). The effect of the reduction is that where a person's income is between £100,000 and £116,210 their effective marginal rate of income tax is 60% (the higher rate of 40% plus a further 20% due to the withdrawal of the personal allowance). Most people will also be paying national insurance contributions at the rate of 2%.
Directors and employees may be able to reduce the impact of this 60% marginal rate by:
- Making a contribution into a personal pension scheme. For example, a person with income of £110,000 will receive tax relief of 60% on a pension contribution of £10,000, so the actual net cost would only be £4,000. A pension contribution might be particularly attractive for someone approaching retirement as upon retirement 25% of the pension fund can be taken as a tax-free lump sum. This would leave in the region of £7,500 invested at a net cost of £1,500 (£10,000 less 60% tax relief and the 25% returned as a lump sum). To be effective for 2012-13 a pension contribution must be paid by 5 April 2013.
- Paying a gift aid donation to charity since the cost of a £1,000 donation is only £400. To be effective for 2012-13 a donation must be paid before the self assessment tax return for that year is submitted, since a claim can be made for a donation to be treated as paid in the previous tax year.
- Making full use of tax free investments such as individual savings accounts to turn taxable investment income into exempt income. To be effective, investments should be in place by the start of the tax year.
- Having bonuses paid in a different tax year. For example, an employee with a salary of £100,000, and who regularly receives a bonus of £15,000, would preserve their personal allowance for 2012-13 if the receipt of that year's bonus was delayed until 2013-14.
- Opting for additional holiday entitlement or shorter working hours instead of a pay rise.
Self-employed people caught in the personal allowance trap have similar options to directors and employees. They can make pension contributions, pay gift aid donations and make use of tax-free investments. However, a self-employed person making up accounts to 31 March or 5 April is unlikely to be aware of their tax position until after the end of the tax year, so it will be difficult to plan for personal pension contributions.
In addition, there are various ways of reducing taxable profits, thus also saving national insurance contributions (2%) as well as income tax (60%). For example, a bonus could be paid to employees, and this has the attraction of not having to be paid until nine months after the end of the accounting period. Alternatively, the amount of tax saving might make it attractive to incur capital expenditure qualifying for the 100% annual investment allowance. To be effective expenditure must be made before the end of the accounting period.
The loss of tax credits
Although not strictly taxes, the working tax credit and the child tax credit are calculated using virtually the same definition of income as for income tax. The tax credit award for 2012-13 is based on a person's income for 2011-12, and the first £10,000 of any increase between the previous year and the current year is disregarded. Therefore, a pay rise or increase in profits of, say, £1,000 will not impact on a tax credits claim until the following tax year. However, the marginal tax rate applicable to the additional income can then be very high.
Most tax credits are clawed back at the rate of 41% above an income threshold which is currently £6,420. This applies to a couples' income rather than on an individual basis. The 41% rate of claw-back means that many families will have a marginal tax rate of 73%, and some with higher incomes will have a marginal rate of 83%.
Example of 73% marginal rate
Alex, a single person with no children, works 40 hours per week and earned £10,000 during 2011-12. For 2012-13 he is entitled to a maximum working tax credit claim of £2,710, but this is reduced to £1,242 (£2,710 – £1,468 (£10,000 - £6,420 = £3,580 at 41%)) as his income exceeds the threshold of £6,420. If Alex had received a pay increase of £1,000 for 2011-12, then his tax credit claim for 2012-13 would instead have been reduced to £832 (£2,710 – £1,878 (£11,000 - £6,420 = £4,580 at 41%)). He has therefore lost tax credits of £410 (£1,242 – £832), and will also pay income tax of £200 (£1,000 at 20%) and national insurance of £120 (£1,000 at 12%) on the additional earnings. This is a total of £730 (£410 + £200 + £120), and thus a marginal tax rate of 73%.
Realistically, there is probably little that a person with this level of income can do to reduce the impact of the 73% marginal tax rate. However, they might consider it not worthwhile having the additional income of £1,000 if it involved extra responsibilities (for an employee) or more work (for a self-employed person).
Example of 83% marginal rate
Zoe, a single parent with two children, works 35 hours per week and earned £45,000 during 2011-12. She pays £300 per week for child care. For 2012-13 Zoe is entitled to maximum tax credits of £21,505, but this is reduced to £5,687 (£21,505 – £15,818 (£45,000 - £6,420 = £38,580 at 41%)). Zoe is a higher rate taxpayer, so if she had received a pay increase of £5,000 for 2011-12, then her tax credit claim for 2012-13 would have been reduced by £2,050 (£5,000 at 41%), and she will also pay income tax of £2,000 (£5,000 at 40%) and national insurance of £100 (£5,000 at 2%) on the additional earnings. This is a total of £4,150 (£2,050 + £2,000 + £100), and thus a marginal rate of 83%.
A person subject to the tax credit 83% tax rate has virtually the same options as a person subject to the personal allowance trap. However, since 6 April 2012 such tax planning has become a bit more complicated as the first £2,500 of any decrease in income between the previous year and the current year is disregarded. For example, assume that Zoe's income remains the same at £50,000 for 2012-13. If she had made a gross personal pension contribution of £5,000 during 2012-13, then her revised income for tax credit purposes would then have been £47,500 (£50,000 - £2,500) as the first £2,500 of the reduction as compared to 2011-12 is ignored. The pension contribution preserves tax credits of £1,025 (£2,500 at 41%), saves income tax of £2,000, but also preserves tax credits of £2,050 for 2013-14 (as the claim for this year will be based on the income for 2012-13). The total saving is £5,075 (£1,025 + £2,000 + £2,050), which is fractionally more than the cost of the pension contribution. The £2,500 disregard means that the rate of tax saving will vary between 81% and 122%. If Zoe had made a pension contribution of less than £2,500 then she would not have saved any tax credits for 2012-13, so tax would have been saved at the rate of 81% (income tax at 40%, and a 41% tax credit saving for 2013-14). If Zoe's income for 2012-13 was already £2,500 less than the 2011-12 figure, then the rate of tax saving would have been 122% (41% + 40% + 41%).
These examples are two extremes of the tax credit system, and many people will fall in between. They will therefore earn substantially more than Alex, but still be subject to a marginal rate of 73%. The maximum possible saving for such people by making a £1,000 gross pension contribution is £1,020 (£410 + £200 + £410) or 102%, although the £2,500 disregard will mean that the saving is more likely to be £610 (£200 + £410) or 61%.
Is there a situation when the effective marginal tax rate on additional income is more than 100%? The answer is yes for some self-employed people who are forced to register for VAT where their income just exceeds the registration limit of £77,000, and they are unable to pass on the cost of registration to customers. In such circumstances the output VAT payable becomes an additional cost for the business.
Michael is a hairdresser who pays income tax at the higher rate of 40%. His turnover for the year ended 5 April 2013 would have been £75,000, but he decided to forego three weeks of his holiday during April 2012 as he needed to save up for the deposit on a new house. His turnover therefore increased to £80,000 (an additional £5,000). To keep things simple assume that VAT registration was necessary from 6 April 2012, that it was not possible to apply for exception from registration, and that no additional costs were incurred as a result of the increase in turnover. The £5,000 of additional income therefore represents profit. The relevant flat rate of VAT (after the 1% discount for the first 12 months of using the scheme) is 12%.
A hairdresser will not normally be in a position to pass on the cost of VAT registration to customers by putting up prices, and will often have very little input VAT that can be recovered. If Michael uses the flat rate VAT scheme then the output VAT payable for the year ended 5 April 2013 will be £9,600 (£80,000 at 12%). This will be deducted from his turnover, so the profit for the year ended 5 April 2013 will be reduced by £4,600 (£9,600 - £5,000). Michael's income tax liability will therefore be reduced by £1,840 (£4,600 at 40%) and his national insurance contributions by £92 (£4,600 at 2%). The net tax cost of making an additional profit of £5,000 is therefore £7,668 (£9,600 - £1,840 - 92), which is a tax rate of 153%. This rate would have been even higher if Michael had paid income tax at the basic rate of 20%.
Unless such a move is a stepping stone to much higher income and profits in the future, it is obviously not beneficial for Michael to do the extra work. For such a person approaching the VAT registration limit it is better to simply do less work by taking more holiday, or instead working in part-time employment where any additional income will not count towards the VAT registration limit. Since registration is based on turnover rather than profit, there is no other practical way of avoiding registration.
Marginal rates of tax can be surprisingly high at quite low levels of income, but careful advance planning may often mitigate the effects. Unfortunately, many people will not become aware of the problem until they file their self-assessment tax returns, and then it will be too late to take any action.