Money tip #128 – The 60% income tax trap and how to avoid it

While most people receive an income tax 'personal allowance', which is an amount of money they can earn before paying tax, those earning over £100,000 a year lose it. But there is a way around this.

The problem

The amount of your personal allowance depends on your age and your total income during the tax year. The personal allowance for someone under 65 is £7,475 for the 2011/12 tax year. But the personal allowance reduces where an individual’s income is above £100,000 – by £1 for every £2 of income above the £100,000 limit. This reduction applies irrespective of age.

That means that someone who is, for example, under 65 and earns more than £114,950 for the 2011/12 tax year will lose their personal allowance in its entirety. This gradual withdrawal of the personal allowance means that a person's earnings between £100,000 and £114,950 are effectively taxed at an eye watering 60%.

How to avoid paying 60% tax

The personal allowance withdrawal technically relates to something called the ‘adjusted net income’ and not your gross salary. For a lot of people these may be one and the same. But the ‘adjusted net income’ used in the withdrawal calculation is an individual’s income which is subject to income tax less specified deductions, which include grossed up contributions to pensions as well as grossed up contributions to charities via gift aid.

What this means is that people whose ‘adjusted net income’ does not exceed £100,000 will receive their full personal allowance. So making sure your 'adjusted net income' doesn't exceed £100,000 is the trick. And how do you do this? Simply by making a pension contribution or using gift aid as stated above. In doing so your adjusted net income will be reduced.

An example

So let's say you are earning £120,000 a year. Ordinarily you wouldn't receive a personal allowance at all – and your net earnings would be £73,219. However by making a £20,000 pension contribution your net annual income becomes £64,209. But your pension pot will have been boosted by £20,000. That means that the pension contribution only cost you £9,010 net (i.e. £73,219 - £64,209) - or in other words you received tax relief at an effective rate of 55%.

Nice! – no need to thank me.

As ever seek financial advice before you do anything.

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