How not to fall foul of a selection of quirks in our tax system.
How much tax will you pay on your bonus? Or on that extra dividend? To twist a phrase, income is income, but not all incomes are the same. Several years down the line, we are still getting to grips with the ‘simplifications’ introduced to the UK tax regime by our beloved former Chancellor, Mr. Osborne, who gave us:
- child benefit clawback for high earners;
- dividend ‘allowance’ (not really an allowance, because it doesn’t ‘reduce’ your income, but just applies a 0% tax rate to a band of dividend income);
- savings ‘allowance’ (not really an allowance, because it doesn’t ‘reduce’ your income, but just applies a 0% tax rate to a band of savings income);
- restriction of pension annual allowance for high earners;
- restriction of tax relief for residential property business finance costs; and new marriage allowance.
What is a ‘marginal tax rate’?
Essentially, it is how much tax you will pay on an extra £1 of income. The marginal income tax rate may be 40% for an employed IT consultant earning £60,000 a year, as every extra £1 will cost 40p in income tax. Or it may be 42% if you factor in National Insurance contributions (NICs) that he or she will usually also have to pay.
However, there are scenarios where the marginal tax rate can be significantly higher than that because income is falling into a particularly punitive ‘band’. We can also have different marginal rates depending on the type of income being added; dividend income is generally cheaper than earnings (but you cannot always choose the type of income you get, of course!) because it has a lower marginal rate than earnings. Rates are for 2018/19, and Scotland has different thresholds, and rates to those quoted (sometimes).
Higher rate tax (£46,350)
People used to paying the basic rate of income tax will find their marginal rate broadly doubles if and when (and to the extent that) their income increases beyond the higher rate threshold of £46,350 in 2018/19. However, employees will not notice the jump so much, as their effective aggregate marginal tax rate, including Class 1 NICs, moves from 32% to 42% – NICs fall from 12% to just 2% at the same threshold, sweetening the pill.
Paying private pension contributions, or making a gift aid donation, ‘pushes’ that threshold higher. A net pension contribution of £2,920, for instance, will push the higher rate threshold to £50,000, leaving everything taxable at no more than 20%.
Child benefit clawback (£50,000)
Child benefit is clawed back if your income (or, if you are a couple looking after relevant children, your partner’s, whichever is the higher) exceeds £50,000. This is done on a sliding scale until it is 100% clawed back where income reaches £60,000.
The marginal rate depends on how much child benefit has been paid in the first place.
Example 1: Child benefit clawback
Bill has three young children, registered for child benefit when they were born, so he receives almost exactly £2,500 a year in automatic child benefit payments. He lives with Gertrude, who works in television and earns in excess of £50,000 a year. Even through Bill receives the child benefit, and he and Gertrude are not married, it is her (higher) income that triggers the clawback – and the clawback is added to her tax bill, not Bill’s. Gertrude’s marginal income tax rate is 65% – 40% as normal, and effectively 25% on top to claw back Bill’s child benefit. Including NICs, her marginal rate is 67%.
This effective rate depends on how many children there are (more eligible children = higher child benefit in the first place), so could be higher or less, depending on the size of the award. If Gertrude’s adjusted income is only a little over the £50,000 threshold at which the clawback is triggered, then she can again look at pension contributions or gift aid payments, effectively to ‘push’ the threshold higher.
Personal allowance restriction (£100,000)
Basically, where income exceeds £100,000, you start to lose your tax-free personal allowance. For the next £23,700 (2018/19) in income, the effective marginal rate is basically increased by half, to around 60%.
Example 2: Personal allowance restriction
Felicity earns exactly £100,000 in salary. She therefore has her full tax-free personal allowance. She is offered a bonus of £5,000. She will lose £2,500 of her personal allowance, so more of her bonus will be taxed at the highest applicable rate of 40%. She will see only £1,900, having paid £3,100 in tax and NICs – an effective rate of 62%.
Dividends are taxed more lightly, and (assuming her £2,000 dividend ‘allowance’ has already been used elsewhere in 2018/19), a £5,000 additional dividend instead of the bonus would cost £2,437.50 – an effective rate of 48.75%.
So far, everyone has been better off for having more income, even though it may sometimes be a lot less net income than one might have expected. But can it be worse than that – can getting a little extra income actually make you worse off overall?
The savings ‘allowance’ falls from £1,000 to £500, basically, when you become a higher rate taxpayer. It then falls to £nil if you become an additional rate taxpayer (income exceeds £150,000).
Example 3: 1,000% tax rate
Brett has an agreed salary of £45,350, and bank interest income of £1,000. Because his income is not over the higher rate threshold, he is entitled to the full savings ‘allowance’ of £1,000, so his interest income is tax-free. His combined tax and NICs bill for 2018/19 is £11,130.
Brett then finds out he had a £10 taxable benefit-in-kind from his employer in 2018/19. His aggregate income now slightly exceeds the 2018/19 higher rate threshold, and his savings ‘allowance’ is restricted to just £500.
His tax/NICs bill rises to £11,235. His employer’s generosity has ended up costing him more than £100 in additional tax, so he is in fact almost £100 worse off than if he’d never had the benefit! The effective marginal tax rate is a little over 1,000%.
Brett’s was an extreme example, where an incremental increase in income has had a larger (but still modest) fixed tax cost. If the surprise benefit-in-kind had been (say) £600 instead of just £10, then the marginal tax rate would have fallen to ‘only’ 53% – not small, but a lot less than 1,000%.
Something similar happens with the new ‘marriage allowance’, whereby one spouse can sacrifice 10% of their tax-free personal allowance so that the other gets an equivalent tax ‘credit’ in their tax bill. The tax saving in 2018/19 can be £237 – but this is lost in full as soon as either spouse’s income exceeds the higher rate threshold.
Here again, a small increase in income can have a large tax cost, and a very large marginal tax rate. But the cost is fixed, so it is only when the ‘nudge’ in income is small that the tax rates are so large.
There are more complex scenarios, involving for example:
- the finance cost (mortgage interest) restriction for residential property landlords, where taxable profits have a completely artificial relationship with real profits – and note that the artificial ‘deemed’ taxable profits are what counts for (say) child benefit clawback or the restriction of personal allowance, both illustrated above; or
- restriction of annual allowance for higher earners – basically, where someone’s adjusted income starts to exceed £150,000, then tax relief for pension contributions can be severely restricted. The effective tax charge can be substantial; and
- student loans, tax credits and universal tax credit, as they interact with other incomes.
Sometimes a relatively small change in income can have unexpected tax consequences – and, with child benefit and/or the new marriage allowance, it can be a change in someone else’s circumstances that affects your tax.
Most of these problems can be addressed with prior warning, but that is not always possible in the real world. Pension contributions and gift aid donations can offer significant savings, but only gift aid can be ‘carried back’ to the preceding year – and a procedure must be followed.
Competent professional advice is essential; if you find out now that income for 2017/18 has just cost you dear, do not file your 2017/18 tax return until you have checked with your professional adviser!