Are you paying Tax at a whopping 60%?

If someone earns more than £100,000 then they may be paying tax at a whopping 60%!  You will not find this rate listed on the HMRC website, but because the personal tax allowance is withdrawn for income over £100,000, earnings of between £100,000 and £121,200 (2015/16) will be taxed at an effective rate of 60%. This can be illustrated by way of an example;

Let’s say someone earns £100,000 and receives a bonus of £1,000. How much tax will be paid on the bonus? The normal tax rate for this level of income is 40% and so the tax on the bonus is £400. However, because of the bonus, it takes the total income over £100,000 at this point the personal allowance starts to be withdrawn. The allowance is withdrawn at a rate of £1 for every £2 of income earned over £100,000 and so in this example £500 of the allowance will be lost. This means that £500 of the normal earnings are now going to be taxed at 40% as they are no longer covered by the allowance. £500 at 40% is £200. Accordingly, the £1,000 bonus will cost £600 in tax (£400 plus £200) i.e. an effective 60% tax rate.

So can anything be done to avoid the additional tax? For personal allowance withdrawal purposes, total earnings are reduced by any payments made in the tax year under gift aid or into a personal pension. Using a pension contribution as an example, if someone pays £800 into their pension HMRC top this up with a further £200 automatically. The £200 represents the basic rate tax relief that is available. As you are a higher rate tax payer you will get higher rate tax relief on the contribution. Normally this means you would get a further £200 back from HMRC directly, and so overall the £1,000 gross contribution has only cost you £600 (£800 paid into the pension less the £200 refund from HMRC). However, because pension contributions reduce total income for personal allowances purposes your personal allowance would be reinstated. This means you would recoup £400 from HMRC rather than £200. The bottom line is that your £1,000 investment into your pension has only cost you £400 (£800 paid in the pension less the £400 refund from HMRC).

To claim the higher rate tax relief it is essential that you make the pension contribution before the end of the tax year (5 April 2016) and complete a tax return for 2015/16.