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When George Harrison wrote the song Taxman he was complaining about a marginal tax rate of 95 percent. The introduction of the additional tax rate of 45 percent from 6 April 2010 for people earning in excess of GBP150,000 is nowhere as bad as that suffered by The Beatles, but some people may find themselves with an even higher marginal tax rate despite their income being well below GBP150,000.
The personal allowance trap
For 2013-14 the normal personal allowance of GBP9,440 is gradually reduced to nil where a person's income exceeds GBP100,000. The reduction is GBP1 for every GBP2 that income exceeds the threshold. Therefore, a person with income of GBP118,880 or more is not entitled to any personal allowance (GBP18,880 (GBP118,880 - GBP100,000)/2 = GBP9,440). The effect of the reduction is that where a person's income is between GBP100,000 and GBP118,880 their effective marginal rate of income tax is 60 percent (the higher rate of 40 percent plus a further 20 percent due to the withdrawal of the personal allowance). Most people will also be paying national insurance contributions at the rate of 2 percent.
Directors and employees may be able to reduce the impact of this 60 percent marginal rate by:
- Making a contribution into a personal pension scheme. For example, a person with income of GBP110,000 will receive tax relief of 60 percent on a pension contribution of GBP10,000, so the actual net cost would only be GBP4,000. A pension contribution might be particularly attractive for someone approaching retirement as upon retirement 25 percent of the pension fund can be taken as a tax-free lump sum. This would leave in the region of GBP7,500 invested at a net cost of GBP1,500 (GBP10,000 less 60 percent tax relief and the 25 percent returned as a lump sum). To be effective for 2013-14 a pension contribution must be paid by 5 April 2014.
- Paying a gift aid donation to charity since the cost of a GBP1,000 donation is only GBP400. To be effective for 2013-14 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 GBP100,000, and who regularly receives a bonus of GBP15,000, would preserve their personal allowance for 2013-14 if the receipt of that year's bonus was delayed until 2014-15.
- 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 percent) as well as income tax (60 percent). 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 percent 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 2013-14 is based on a person's income for 2012-13, and the first GBP5,000 of any increase between the previous year and the current year is disregarded. Therefore, a pay rise or increase in profits of, say, GBP1,000 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.
Unless just child tax credits are received, tax credits are clawed back at the rate of 41 percent above an income threshold of GBP6,420. This applies to a couples' income rather than on an individual basis. The 41 percent rate of claw-back means that many families will have a marginal tax rate of 73 percent, and some with higher incomes will have a marginal rate of 83 percent.
Example of 73 percent marginal rate
Alex, a single person with no children, works 40 hours per week and earned GBP10,000 during 2012-13. For 2013-14 he is entitled to a maximum working tax credit claim of GBP2,710, but this is reduced to GBP1,242 (GBP2,710 - GBP1,468 (GBP3,580 (GBP10,000 - GBP6,420) at 41 percent)) as his income exceeds the threshold of GBP6,420. If Alex had received a pay increase of GBP1,000 for 2012-13, then his tax credit claim for 2013-14 would instead have been reduced to GBP832 (GBP2,710 - GBP1,878 (GBP4,580 (GBP11,000 - GBP6,420) at 41 percent)). He has therefore lost tax credits of GBP410 (GBP1,242 - GBP832), and will also pay income tax of GBP200 (GBP1,000 at 20 percent) and national insurance contributions of GBP120 (GBP1,000 at 12 percent) on the additional earnings. This is a total of GBP730 (GBP410 + GBP200 + GBP120), and thus a marginal tax rate of 73 percent.
Realistically, there is probably little that a person with this level of income can do to reduce the impact of the 73 percent marginal tax rate. However, they might consider it not worthwhile having the additional income of GBP1,000 if it involved extra responsibilities (for an employee) or more work (for a self-employed person).
Example of 83 percent marginal rate
Zoe, a single parent with two children, works 35 hours per week and earned GBP45,000 during 2012-13. She pays GBP300 per week for child care. For 2013-14 Zoe is entitled to maximum tax credits of GBP21,585, but this is reduced to GBP5,767 (GBP21,585 - GBP15,818 (GBP38,580 (GBP45,000 - GBP6,420) at 41 percent)). Zoe is a higher rate taxpayer, so if she had received a pay increase of GBP5,000 for 2012-13, then her tax credit claim for 2013-14 would have been reduced by GBP2,050 (GBP5,000 at 41 percent), and she will also pay income tax of GBP2,000 (GBP5,000 at 40 percent) and national insurance contributions of GBP100 (GBP5,000 at 2 percent) on the additional earnings. This is a total of GBP4,150 (GBP2,050 + GBP2,000 + GBP100), and thus a marginal rate of 83 percent.
A person subject to the tax credit 83 percent tax rate has virtually the same options as a person subject to the personal allowance trap. However, such tax planning is a bit more complicated as the first GBP2,500 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 GBP50,000 for 2013-14. If she had made a gross personal pension contribution of GBP5,000 during 2013-14, then her revised income for tax credit purposes would then have been GBP47,500 (GBP50,000 - GBP2,500) as the first GBP2,500 of the reduction as compared to 2012-13 is ignored. The pension contribution preserves tax credits of GBP1,025 (GBP2,500 at 41 percent), saves income tax of GBP2,000, but also preserves tax credits of GBP2,050 for 2014-15 (as the claim for this year will be based on the income for 2013-14). The total saving is GBP5,075 (GBP1,025 + GBP2,000 + GBP2,050), which is fractionally more than the cost of the pension contribution. The GBP2,500 disregard means that the rate of tax saving will vary between 81 percent and 122 percent. If Zoe had made a pension contribution of less than GBP2,500 then she would not have saved any tax credits for 2013-14, so tax would have been saved at the rate of 81 percent (income tax at 40 percent, and a 41 percent tax credit saving for 2014-15). If Zoe's income for 2013-14 was already GBP2,500 less than the 2012-13 figure, then the rate of tax saving would have been 122 percent (41 percent + 40 percent + 41 percent).
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 percent. The maximum possible saving for such people by making a GBP1,000 gross pension contribution is GBP1,020 (GBP410 + GBP200 + GBP410) or 102 percent, although the GBP2,500 disregard will mean that the saving is more likely to be GBP610 (GBP200 + GBP410) or 61 percent.
Child benefit income tax charge
For a few unlucky people, earning extra income can mean that they actually end up with less net of tax income than before the increase. This is where they are subject to the child benefit income tax charge in addition to the loss of tax credits. The child benefit income tax charge applies where a person receives child benefit and their income exceeds GBP50,000. Child benefit is a tax-free payment that can be claimed in respect of children, and the tax charge in effect removes the benefit for those on higher incomes. If income is between GBP50,000 and GBP60,000, the income tax charge is 1 percent of the amount of child benefit received for every GBP100 of income over GBP50,000.
It is possible for someone to still be entitled to tax credits even when their income is between GBP50,000 and GBP60,000 if they have several children and/or have high child care costs. As seen above, the marginal tax rate on any extra income in this situation is 83 percent, but this will be even higher if the extra income also results in an increased child benefit tax charge. For example, with three children, the amount of child benefit for 2013-14 is GBP2,449. For each extra GBP1,000 of income between GBP50,000 and GBP60,000 the income tax charge would increase by GBP245 - a rate of 24.5 percent. So the overall marginal tax rate is 107.5 percent, and this would be higher still if there were more children. With such marginal tax rates, pension contributions can effectively be made for free.
Are there any other situations when the effective marginal tax rate on additional income is more than 100 percent? 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 GBP79,000, 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 self-employed hairdresser who pays income tax at the higher rate of 40 percent. His turnover for the year ended 5 April 2014 would have been GBP75,000, but he decided to forego three weeks of his holiday during April 2013 as he needed to save up for the deposit on a new house. His turnover therefore increased to GBP80,000 (an additional GBP5,000). To keep things simple assume that VAT registration was necessary from 6 April 2013, 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 GBP5,000 of additional income therefore represents profit. The relevant flat rate of VAT (after the 1 percent discount for the first 12 months of using the scheme) is 12 percent.
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 2014 will be GBP9,600 (GBP80,000 at 12 percent). This will be deducted from his turnover, so the profit for the year ended 5 April 2014 will be reduced by GBP4,600 (GBP9,600 - GBP5,000). Michael's income tax liability will therefore be reduced by GBP1,840 (GBP4,600 at 40 percent) and his national insurance contributions by GBP92 (GBP4,600 at 2 percent). The net tax cost of making an additional profit of GBP5,000 is therefore GBP7,668 (GBP9,600 - GBP1,840 - 92), which is a tax rate of 153 percent. This rate would have been even higher if Michael had paid income tax at the basic rate of 20 percent.
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.