THE 60% INCOME TAX RATE – IFS LATEST STUDY: IDEAS AND OPPORTUNITIES/IDENTIFYING THE OPPORTUNITY/SELLING THE PROBLEM
The Institute for Fiscal Studies has criticised various aspects of the current tax system with the main criticism being directed at the 60% income tax rate suffered by higher earners. However, with a little bit of simple planning your clients need not pay it.
The Institute of Fiscal Studies (IFS) has widely criticised the tax system by saying it is too complicated. Paul Johnson, the IFS Director used several examples to illustrate the current Government’s failure to improve the tax system.
One example of “tax complexity” and unjustifiably high effective rates result was the Government’s decision to raise the threshold for income tax but not for national insurance contributions (NICs). This, Johnson said, ‘has resulted in more than one million low paid workers paying NICs but not income tax.’
Other problems include legacies left over from previous governments. Johnson said the government had ‘followed in the pusillanimous steps of its predecessors’ by failing to revalue properties for council tax in England.
Johnson said, ‘Council tax, which is our main property tax, is assessed on relative property values which will soon be a quarter of a century out of date.’
Not letting Labour off the hook, Johnson added that the last government ‘could fill its own hall of shame’ with damaging tax policy. This included the introduction – and abolition – of 0% corporation tax for the lowest profit companies.
But the main criticism was focused on the 60% effective tax rate for those with incomes of £100,000 and over. This is caused by the loss of the personal allowance which is reduced by £1 for every £2 where an individual’s “adjusted net income” (see below) is above the income limit of £100,000.
Broadly “adjusted net income” is total ‘net’ income less any gross gift aid contributions and gross pension payments which have received relief at source.
‘Net’ income includes salary, bonuses, certain taxable benefits, investment income and other income (such as property income less any trading losses, and payments made gross to pension schemes).
Let’s look at an example comparing the tax paid by a person with adjusted net income of £100,000 with the tax paid by a person with adjusted net income of £120,000 to show how this 60% rate emerges:
Adjusted net income of £100,000
£
Income 100,000
Personal allowance (10,000)
Taxable income 90,000
Tax payable £
£31,865 @ 20% 6,373
£58,135@ 40% 23,254
Total tax payable 29,627
Adjusted net income of £120,000
£
£31,865 @ 20% 6,373
£88,135@ 40% 35,254
Total tax payable 41,627
Therefore on the additional £20,000 of income the individual is subject to additional tax of £12,000 which equates to an effective income tax rate on the “offending” £20,000 slice of 60%.
Separately and of interest to financial planners the IFS expects there to be 5.3 million higher and additional-rate taxpayers in 2015/16, up from 3.3 million in 2010/11.
COMMENT:
In determining how to direct their efforts and spend their time in relation to the provision of advice , financial planners will inevitably focus on wealthier clients with challenges and objectives which are relatively complex, for which the consequences of “getting it wrong” are detrimental and for which answers cannot be readily found themselves. Tax related challenges usually tick these boxes.
The reported projected increase in higher and additional rate taxpayers should increase the “population” of those who will value (and pay for) financial advice. And avoiding an effective 60% tax rate should be something that will capture the attention of those affected – higher rate taxpayers with income of more than £100,000.
As explained above, the loss of the personal allowance (which results in the 60% rate) is based on an individual’s adjusted net income so, on tax grounds, it would pay to reduce adjusted net income to £100,000 to retain the personal allowance and not suffer such a high rate of tax. If there is available cash, pension contributions and gift aid donations can both achieve this purpose. Both require taxpayer “comfort” in relation to re-attributing available funds but the “loss” to available net income will only be 40% of the gross income – 60% being lost in tax if no action is taken.
Consider this example
An individual has earned income of £130,000. As this is above £120,000 they would lose full entitlement to their personal allowance and would pay tax as follows:
£
£31,865 @ 20% 6,373
£98,135@ 40% 39,254
Total tax payable 45,627
Let’s say that after seeking appropriate advice the individual decides to make a pension contribution of £30,000 to a registered pension scheme via salary exchange. This would have the effect of bringing their adjusted net income down to £100,000.
£
Income 100,000
Personal allowance (10,000)
Taxable income 90,000
Tax payable £
£31,865 @ 20% 6,373
£58,135@ 40% 23,254
Total tax payable 29,627
So by making a pension contribution of £30,000, a tax saving of £16,000 is achieved and the net cost to the individual is only £14,000.
And just to provide additional reassurance this is planning that, despite being super effective falls the “right side of the line” in determining whether planning is likely to be seen as aggressive or acceptable by HMRC.
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