George Osborne has always prided himself on being a low tax Conservative chancellor and, to his credit, he has done much to reduce the Income Tax burden on the lower paid despite a continuing fiscal straitjacket. However, much has recently been talked about the squeezed middle who, rather than benefiting from the decline in Personal Allowance rates, are actually suffering from it. This anomaly is probably not intentional and, in all probability, will be addressed in the future but, in the meantime, the unpleasant fact is that those earning between £100,000 and £120,000 a year are continuing to pay an effective rate of tax of 60%. Far from enjoying a low tax environment, this group is almost up there in Denis Healey’s “squeaking pips” bracket, and it’s a group that those who provide tax services are hearing from in increasing numbers.
Let’s just look first at how this particular minefield arose in the first place. It’s all down to the fact that, for every two pounds people earn over £100,000, one pound of the Personal Allowance is lost. This means that those earning between £100,000 and £120,000 are effectively paying 60% tax on that income and not the 40% rate they would expect to be paying. In fact, if you add National Insurance into the equation, the rate rises to an eye-watering 62%. With figures like these it’s easy to see why demand for accountancy firms offering tax services are in high demand.
It would clearly come as a bit of a shock if you were earning £100,000 and you were awarded a bonus of, say, £10,000. The 60% tax trap would mean you received a net payment of only £4,000 at best.
Thankfully, astute providers of tax services will be able to advise you on ways to navigate this situation if you are unlucky enough to find yourself caught up in it.
Employees and Sole Traders The most obvious thing to do, and a common suggestion from professionals offering tax services, is to try and avoid going over the £100,000 p.a. threshold in terms of your adjusted net income i.e. after pension and charitable contributions have been deducted from your gross income. Take, for example, those who earn £120,000, the level at which the £10,000 Personal Allowance is reduced to zero.
This group could pay a gross contribution into their pension of £ 20,000 which involves an actual payment of £16,000. However, because they would now be eligible for the full Personal Allowance, the actual cost would drop by £8,000 as the result of the reduced tax liability. This would leave them with a pension fund asset of £20,000 which had only cost £8,000. This represents tax relief of 60% on the original payment – not a bad way of turning the 60% Tax Trap to one’s advantage and it’s a process that any good provider of tax services can help you with.
Company Owners Alternatively, those who control their own companies can sidestep the onerous 60% rate by the use of dividend payments ( assuming a sufficient level of profitability). Professionals who provide tax services to company directors suggest that those who want to take over £100,000 p.a. out of their company should think of taking £100,000 in salary and ,say, another £20,000 in the form of a dividend.
Because of the lower tax regime on dividend payments, those doing this in 2014/2015 would still lose their Personal Allowance but would reduce the tax rate on the excess over £100,000 to between 37.5% and 47.2%.
It would also make sense for married owner managers to transfer half their shares to their spouse so that they could each draw dividends of £100,000 and enjoy the full Personal Allowance. The flat rate Income Tax on the dividends of 10% plus 22% Corporation Tax payable on the profit required for this would equate to an effective tax rate of around 32%.
If you’re concerned about being hit by the 60% income tax trap then our tax services team will be happy to discuss your requirements.
To find out how Baker Tilly’s range of tax services can help you click here http://www.bakertilly.co.uk/services/tax/tax.aspx