In 2015 - 2016, a person with an income of £121,200 or more is not entitled to any personal allowance. David Harrowven explains the impact this will have on individuals
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When George Harrison wrote the song Taxman, he was complaining about a marginal tax rate of 95%. The present additional tax rate of 45% for people earning in excess of £150,000 is nowhere as bad as that suffered by The Beatles, but some people can find themselves with a much higher marginal tax rate despite their income being well below £150,000.
Personal allowance trap
For 2015-16, the personal allowance of £10,600 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 £121,200 or more is not entitled to any personal allowance ((£121,200 – £100,000)/2 = £10,600). The effect of the reduction is that where a person’s income is between £100,000 and £121,200, their effective marginal rate of income tax is 60% (the higher tax 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 gross 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. Upon retirement, 25% of the pension fund can be taken as a tax-free lump sum, leaving in the region of £7,500 invested at a net cost of £1,500 (£10,000 less 60% tax relief and 25% returned as a lump sum). There is complete flexibility as regards withdrawing the balance of the fund, although normal rates of income tax will apply. To be effective for 2015-16, a pension contribution must be paid by 5 April 2016.
- Making a gift aid donation to charity since the cost of a £1,000 donation is only £400. To be effective for 2015-16, a donation can be paid up until the time that the self-assessment tax return for that year is submitted because 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 who regularly receives a bonus of £20,000, would preserve their full personal allowance for 2015-16 if the receipt of that year’s bonus was delayed until 2016-17.
- 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 and gift aid donations, and can 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 pension contribution planning will be difficult.
A self-employed person might also be able to reduce their taxable profits, thereby saving national insurance contributions (2%) as well as income tax (60%). For example, a bonus could be paid to employees - this has the attraction of not having to be paid until nine months after the end of the accounting period. Alternatively, the tax saving might make it attractive to incur capital expenditure qualifying for the 100% annual investment allowance. To be effective, expenditure must be before the end of the accounting period.
Loss of tax credits
Although not strictly a tax, working tax credit and child tax credit are calculated using virtually the same definition of income as for income tax. The tax credit award for 2015-16 is based on a person’s income for 2014-15, and the first £5,000 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. The marginal tax rate applicable to the additional income can then, however, be very high.
Unless there is entitlement to just child tax credits, tax credits are currently clawed back at the rate of 41% above an income threshold of £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 it could be 83% for some with higher incomes.
The situation will be much worse from 2016-17 because the rate of claw back is to be increased to 48% and the income threshold reduced to £3,850. The income rise disregard will fall from £5,000 to £2,500.
Example of 73% marginal rate
Alex, a single person with no children, works 40 hours a week and earned £11,000 during 2014-15. For 2015-16, he is entitled to a maximum working tax credit claim of £2,770, but this is reduced to £892 (£2,770 – ((£11,000 - £6,420) at 41%)). If Alex had received a pay increase of £1,000 for 2014-15, then his tax credit claim for 2015-16 would instead have been reduced to £482 (£2,770 ((£12,000 - £6,420) at 41%)). He has therefore lost tax credits of £410 and will also pay income tax of £200 (£1,000 at 20%) and national insurance contributions of £120 (£1,000 at 12%) on the additional earnings. This is a total of £730 which is of course 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 tax credit withdrawal. 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 a week and earned £45,000 during 2014-15. She pays £300 per week for child care. For 2015-16, Zoe is entitled to maximum tax credits of £21,805, but this is reduced to £5,987 (£21,805 – ((£45,000 - £6,420) at 41%)). Zoe is a higher rate taxpayer, so if she had received a pay increase of £5,000 for 2014-15, then her tax credit claim for 2015-16 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 contributions of £100 (£5,000 at 2%) on the additional earnings. This is a total of £4,150, resulting in a marginal rate of 83%.
A person subject to the tax credit 83% tax rate has virtually the same options as someone caught by the personal allowance trap. However, such tax planning is a bit more complicated because 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 unchanged at £50,000 for 2015-16. If she had made a gross personal pension contribution of £5,000 during 2015-16, then her revised income for tax credit purposes would be £47,500 (£50,000 - £2,500) as the first £2,500 of the reduction as compared to 2014-15 is ignored. The pension contribution preserves tax credits of £1,025 (£2,500 at 41%), saves income tax of £2,000, but will also preserve tax credits of £2,400 for 2016-17 (£5,000 at the increased claw back rate of 48% - the claim for this year will be based on the income for 2015-16). The total saving is £5,425, which is more than the cost of the pension contribution. The £2,500 disregard means that the current rate of tax saving will vary between 88% and 129%. If Zoe had made a pension contribution of less than £2,500, then she would not have saved any tax credits for 2015-16 so tax would have been saved at the rate of 88% (income tax at 40% and 48% tax credit saving for 2016-17). If Zoe’s income for 2015-16 was already £2,500 less than the 2014-15 figure, then the rate of tax saving would have been 129% (41% + 40% + 48%).
These examples are two extremes of the tax credit system and many people will fall somewhere 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 £1,090 (£410 + £200 + £480 (£1,000 at 48%)) or 109%, although the £2,500 disregard will mean that the saving is more likely to be £680 (£200 + £480) or 68%.
Child benefit income tax charge
For a very 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’s income exceeds £50,000 and they (or their partner) receives child benefit. Child benefit is a tax-free payment which 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 £50,000 and £60,000, then the income tax charge is 1% of the amount of child benefit received for every £100 of income over £50,000.
It is currently possible for someone to still be entitled to tax credits when their income is between £50,000 and £60,000 if they have several children and/or have high child care costs (it is unlikely that there will be any tax credit entitlement at this level of income once the 2016-17 changes come in). As already seen, the marginal tax rate on any extra income at this income level is 83%, but this will be even higher if the additional income also results in an increased child benefit tax charge. For example, with three children, the amount of child benefit for 2015-16 is £2,501. For each £1,000 of additional income between £50,000 and £60,000, the income tax charge will increase by £250 – a rate of 25%. So the overall marginal tax rate is 108% - higher still if more than three children. With such marginal tax rates, pension contributions can effectively be made for free.
Starting rate band
The starting rate of 0% applies where savings income falls within the first £5,000 of taxable income. Seems simple enough, but take a person with savings income of £100 and non-savings income of £15,500. The 0% rate applies to the savings income (£15,500 + £100 - £10,600 = £5000). But add another £100 of non-savings income to the mix and the savings income will then be taxed at 20%. The additional income of £100 will also be taxed at 20%, so the effective tax rate is 40%. National insurance contributions at 9% or 12% could also be due depending on what the non-savings income is. Tax credits might be clawed back as well, so in 2016-17 the whole of the additional income of £100 could be lost to tax (40% + 12% + 48% = 100%).
Of course in this scenario, the tax involved is relatively small and moving savings into an individual savings account is an easy fix. But it shows that marginal tax rates are not always obvious, and pensioners with higher amounts of savings income will need to be particularly careful when withdrawing income using flexible pension arrangements.
Are there any other situations 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 £82,000 and they are unable to pass on the cost of registering to their customers. In such circumstances, the output VAT payable effectively becomes an additional business cost.
Michael is a self-employed hairdresser who pays income tax at the higher rate of 40%. His turnover for the year ended 5 April 2016 would have been £80,000, but he decided to forego three weeks of holiday during April 2015 because he needed to save for the deposit on a new house. His turnover therefore increased to £85,000 (an additional £5,000). To keep things simple, let’s assume VAT registration was necessary from 6 April 2015, that it was not possible to apply for exception from registration and 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 recoverable input VAT. If Michael uses the flat rate VAT scheme, then the output VAT payable for the year ended 5 April 2016 will be £10,200 (£85,000 at 12%). This will be deducted from turnover, so his profit for the year ended 5 April 2016 will be reduced by £5,200 (£10,200 - £5,000). Michael’s income tax liability will be reduced by £2,080 (£5,200 at 40%) and his national insurance contributions by £104 (£5,200 at 2%). The net tax cost of making an additional profit of £5,000 is therefore £8,016 (£10,200 - £2,080 - £104), which is a tax rate of 160%. The percentage would have been even higher if Michael had paid income tax at just the basic rate.
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 undertake 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 can often mitigate the effects. Unfortunately, many people will not become aware of the problem until they file their self-assessment tax return and then it will be too late to take any action.