By Stuart Robb (pictured), partner, Baker Tilly
"The Chancellor never mentioned that those earning between £100,000 and £120,000 would pay 60% tax, so how did he get away with this?
Are you one of the squeezed-middle paying tax at 60%? Much attention has been given to raising the personal allowance to £10,000, but little has been said about the knock-on effect this has on those earning just above £100,000 who now pay tax at 60% - much higher than the 45% tax payable by those earning more than £150,000.
The personal allowance reduces by £1 for every £2 of income above £100,000. This produces an effective tax rate of 60% on income between £100,000 and £120,000. If you are employed or self-employed this becomes 62% once you add in the national insurance.
So the increase in the personal allowance to £10,000 now means that, even though you are a 40% taxpayer, you could actually be paying 60% tax on up to £20,000 of your income. It would come as an unpleasant surprise to learn that your £10,000 pay rise or bonus could be worth as little as £3,800 after tax.
How to take advantage of the 60% tax trap
The withdrawal of the personal allowance is not linked to your total income, but is triggered if your ‘adjusted net income’ exceeds £100,000. For many, these numbers will be one and the same, but your adjusted net income is after deducting pension contributions and charitable donations. So the trick is to ensure that your adjusted net income is no more than £100,000.
If your salary was £120,000, you would not receive any personal allowance; but if you paid a gross pension contribution of £20,000, you would be entitled to a full personal allowance. You would need to pay £16,000 to the pension company, but your remaining tax liability would drop by £8,000. So you would be £8,000 out of pocket, but as there would be £20,000 in your pension fund you would have obtained 60% tax relief on the payment.
How else can I plan to avoid 60% tax?
f you control your own company, there are other ways to avoid 60% tax. Obviously, you could limit your taxable income to £100,000, but if that is unrealistic you should take the excess as dividends. You should probably be taking dividends instead of salary anyway as this avoids the payment of national insurance and, even though the company’s corporation tax liability rises as your salary falls, the overall tax rate is lower.
If you take income from your company of £120,000 during 2014/15 and this includes at least £20,000 of gross dividend income (i.e. £18,000 cash dividend), you would still lose your personal allowance but the effective tax rate on your dividend income above £100,000 would be no more than 47.2% and could be as low as 37.5%.
You should also consider transferring 50% of your shares to your spouse. This could have capital gains tax advantages in the event of a sale of the company, but more importantly this potentially allows you, as a couple, to receive gross dividend income of £200,000 (i.e. cost dividend of £180,000) and still keep your personal allowances intact. Taking the income tax and corporation tax together, the total tax payable would equate to about 32% of the profits needed to pay the dividend.
The Chancellor didn’t specifically state that those earning up to £100,000 would pay 40%, top earners would pay 45% and those earning between £100,000 and £120,000 would pay 60%, but that is the crazy effect of the rules on personal allowances."