High earners may find that they lose their personal allowance. This may land them with an unexpected tax bill if their earnings for a tax year are higher than expected (for example as a result of a surprise bonus payment) and the personal allowance is included in their tax code.
Abatement of the personal allowance
The basic personal allowance for 2015/16 is £10,600. However, this is reduced by £1 for every £2 by which income exceeds £100,000. The measure of income for these purposes is `adjusted net income’.
This means that anyone who has adjusted net income of £121,200 or above will not have a personal allowance for 2015/16.
Avoid the abatement zone
Where income falls in the abatement zone, i.e. between £100,000 and £121,200 for 2015/16, the marginal rate of tax is a very high 60%. This is the usual 40% rate plus the impact of the loss of the personal allowance.
The slice of income between £121,200 (the level at which the personal allowance is fully lost) and £100,000 (the level above which abatement starts) is £21,200.
Tax at 40% on this band is £8,480 (£21,200 @ 40%).
The personal allowance is £10,600. Losing the allowance means that the taxpayer pays tax on a further £10,600 @ 40% = £4,240.
The total tax hit on this slice of income is £12,720 (£8,480 plus £4,240), which is a whopping 60% of £21,200. Thus the effective marginal rate of tax in the abatement zone is 60%
Reduce income to preserve the personal allowance
Reducing income to below £100,000 will mean that the personal allowance is not lost and the horrendous 60% effective tax rate is avoided. There are various ways this can be achieved:
- Transferring income-producing assets to a spouse or civil partner – for example, for a taxpayer with significant dividend or savings income, transferring the shares or savings to a lower earnings spouse or civil partner will save tax and help retain the personal allowance.
- Delaying dividend payments –deferring dividend income to a later tax year can be beneficial if it helps keep income in the current year below the abatement zone. A similar strategy can be adopted in relation to bonus payments.
- Make pension payments - adjusted net income can be reduced by making pension contributions, which is in itself beneficial due to the higher rate relief available on contributions up to the available annual allowance.
- Charitable donations – making charitable donations will also reduce adjusted net income (although the individual loses the benefit of that income).
Tax code shock
If you think that your income is likely to be above £100,000 it is perhaps better to have your tax code adjusted to reflect the loss of the personal allowance. Otherwise, you will receive the benefit of the personal allowance during the tax year, only to face a high bill once you have done your self-assessment return and find the allowance has been clawed back.
Read earlier tax blogs: