Many UK taxpayers are unaware that earning between £100,000 and £125,140 can result in an effective marginal tax rate of 60%. This phenomenon occurs due to the gradual withdrawal of the Personal Allowance for incomes above £100,000. In this article, we'll explore how this happens, who it affects, and what you can do to mitigate its impact.

What Is the Personal Allowance?

The Personal Allowance is the amount of income you can earn each tax year without paying Income Tax. For the 2023/2024 tax year, the standard Personal Allowance is £12,570.

The Tapering of the Personal Allowance

Once your Adjusted Net Income exceeds £100,000, your Personal Allowance decreases by £1 for every £2 of income above this threshold. This means that by the time your income reaches £125,140, your Personal Allowance is reduced to £0.

How the Reduction Works:

• Income between £100,000 and £125,140: Personal Allowance reduces from £12,570 to £0.
• Rate of Reduction: £1 reduction for every £2 over £100,000.

The 60% Marginal Tax Rate Explained

The standard Income Tax rates for England, Wales, and Northern Ireland are:

• Basic Rate (20%): Up to £37,700 (after Personal Allowance)
• Higher Rate (40%): £37,701 to £150,000
• Additional Rate (45%): Over £150,000

However, due to the loss of the Personal Allowance, the effective marginal tax rate between £100,000 and £125,140 becomes 60%. Here's why:

Breakdown:

1. Income Tax: For every additional £1 earned over £100,000, you pay 40p in Income Tax (Higher Rate).
2. Loss of Personal Allowance: Additionally, you lose 50p of Personal Allowance for every extra £1 earned (since £1 loss for every £2 over £100,000).
3. Tax on Lost Allowance: The lost Personal Allowance is taxed at 40%, resulting in an extra 20p tax (40% of 50p).

Total Tax on Each Extra £1:

• Income Tax: 40p
• Tax on Lost Allowance: 20p
• Total: 60p

Therefore, the effective marginal tax rate is 60% on income between £100,000 and £125,140.

Example Calculation

Let's illustrate this with an example:

Who Is Affected?

• High Earners: Individuals with Adjusted Net Income between £100,000 and £125,140.
• Dual-Income Households: Families where both partners have incomes in this range.
• Those Receiving Bonuses: One-off payments that push income over £100,000 can trigger the allowance reduction.

How to Mitigate the Impact

1. Pension Contributions

   • Make Additional Pension Contributions: Contributions reduce your Adjusted Net Income.
   • Benefit: Restores Personal Allowance and provides tax relief at your highest marginal rate.

2. Charitable Donations

   • Gift Aid Donations: Charitable giving can reduce your Adjusted Net Income.
   • Benefit: Lowers taxable income and may restore Personal Allowance.

3. Salary Sacrifice Schemes

   • Exchange Salary for Benefits: Such as additional pension contributions or childcare vouchers.
   • Benefit: Reduces taxable income and preserves Personal Allowance.

4. Tax-Efficient Investments

   • Individual Savings Accounts (ISAs): Income and gains are tax-free.
   • Enterprise Investment Scheme (EIS) & Seed Enterprise Investment Scheme (SEIS): Offer tax reliefs that can reduce taxable income.

Conclusion

Understanding the implications of earning over £100,000 is crucial for effective tax planning. The 60% marginal tax rate due to the tapering of the Personal Allowance can significantly impact your net income. By taking proactive steps like increasing pension contributions or making charitable donations, you can reduce your Adjusted Net Income, regain your Personal Allowance, and lower your effective tax rate.