The 60% tax trap

Tony Wickenden Tax Planning

It has been stated that only around 3 per cent of the population will earn the £150,000 (or more) that triggers the new additional rate of 50 per cent – and the effective removal of higher-rate tax relief on pension contributions. A bigger proportion earn more than £100,000 and will be caught by the withdrawal of the basic personal allowance.

Most would express a little surprise at the fact that the removal of the basic personal allowance results in an effective 60 per cent income tax rate on a slice of income of about £13,000 sitting on top of the first £100,000 of income, especially as this effective 60 per cent rate is squeezed between the application of a 40 per cent rate on income either side of the £100,000 and £113,000 break points.

This 60 per cent rate results because the basic personal allowance is withdrawn at the rate of £1 for every £2 over £100,000 until the basic personal allowance has disappeared.

So the offending £2 will bear tax of its own at 40 per cent, that is 80p, and also trigger the removal of tax freedom (through the basic personal allowance) on another £1 giving rise to an additional 40p of tax.

So a total of £1.20 tax will be payable on £2 of income – and that equates to 60 per cent tax. The income caught in this 60 per cent trap is, effectively, the basic personal allowance x 2 – that is, around £13,000.

That is it in summary but some of you may want a little more detail and, as with most new tax changes, the legislation does not disappoint. Here is a bit more detail. From 2010/11, the basic personal allowance will be subject to a single income limit of £100,000. Where an individual’s adjusted net income is below or equal to the £100,000 limit, they will continue to be entitled to the full amount of the basic personal allowance.

This is a key phrase to get to grips with – adjusted net income. Not that it’s new (see below) but advisers may not have had to consider it in much detail to date.

Where an individual’s adjusted net income is above the income limit of £100,000, as stated above, the amount of the allowance will be reduced by £1 for every £2 above the income limit. The basic personal allowance can be reduced to nil.
For example, if we assume the basic personal allowance for 2010/11 remains at £6,475, then at an adjusted net income of £112,950 or above, no basic personal allowance is available.

It is worth noting, in this context, that the personal allowance will not change if the RPI is negative. In such circumstances the legislative default (section 57 Income Tax Act (ITA) 2007) applies and there will be no change to the personal allowance.

Adjusted net income (section 58 ITA 2007) is the measure of an individual’s income that is used in calculating the existing income-related reductions to personal allowances for those aged 65 and over.

Adjusted net income is calculated in a series of steps. The starting point is net income, which is the individual’s total income (section 23 ITA 2007) subject to income tax less specified deductions, the most impor-tant of which are trading losses and payments made gross to pension schemes (section 24 ITA 2007).

This net income is then reduced by the grossed-up amount of the individual’s Gift Aid contributions and the grossed-up amount of the individual’s pension contributions which have received tax relief at source.

The final step is to add back any relief for payments to trade unions or police organisations deducted in arriving at the individual’s net income.
The result is the individual’s adjusted net income. This definition will be considered in a little more detail in next week’s article.

It is interesting that adjusted net income is used to determine the availability or reduction of age allowance. Perhaps this is not so surprising though, as the process of allowance withdrawal works in the same way for the basic personal allowance as it does for age allowance.

As well as looking at the definition of adjusted net income in a bit more detail next week, I will also look at some effective planning strategies to retain the allowance.