The personal allowance is £11,500 in 2017/2018, but £1 of allowance is lost for every £2 of adjusted net income over £100,000 – creating an effective 60% tax rate on income between £100,000 and £123,000.
Adjusted net income is essentially taxable income less the gross amount of member contributions to relief at source pensions and the grossed up amount of gift aid donations.
It’s usually possible to reclaim some or all of the lost personal allowance with a pension contribution – benefitting from up to 60% tax relief. Gift aid donations work in a similar way.
Example
In 2017/2018, Fred gets £96,000 salary, £9,600 bonus and £2,500 taxable benefits. He also gets £500 ISA interest plus £400 in dividends. ISA interest isn’t taxable, but dividends within the dividend allowance are taxable at 0%. Fred pays 2.5% of basic salary and his employer 5% into a group personal pension. Fred’s adjusted income (his taxable income plus employer contributions) is £113,300 so he isn’t caught by the tapered annual allowance. The overall £7,200 contribution is well within the £40,000 annual allowance.
Salary £96,000
Bonus £9,600
Taxable benefits £2,500
Dividends £400
Taxable income for 2017/2018 £108,500
Less member contributions to relief at source pensions (£96,000 x 2.5%) (£2,400)
Adjusted net income for 2017/2018 £106,100
As Fred’s adjusted net income exceeds £100,000 by £6,100, his personal allowance reduces by £3,050, from £11,500 to £8,450.
Fred has already kept some of his personal allowance by contributing to the group personal pension. He could reclaim the rest by making a £6,100 gross member contribution to a relief at source pension, reducing his adjusted net income to £100,000. He’d need to make a £4,880 net contribution by 5 April 2018.
He claims the personal allowance and higher rate tax relief via self-assessment, turning the effective cost of a £6,100 increase to his pension fund into just £2,440. (Those in net pay schemes can achieve the same outcome through reducing taxable income rather than adjusted net income.)
| No pension contributions | £2,400 pension contribution | £2,400 + £6,100 pension contributions | ||||
| Taxable income | £108,500 | £108,500 | £108,500 | |||
| Adjusted net income | £108,500 | £106,100 | £100,000 | |||
| Personal allowance | £7,250 | £0 | £8,450 | £0 | £11,500 | £0 |
| Basic rate band (20%) | £33,500 | £6,700 | £35,900 | £7,180 | £42,000 | £8,400 |
| Higher rate band (40%) | £67,350 | £26,940 | £63,750 | £25,500 | £54,600 | £21,840 |
| Dividend allowance (0%) | £400 | £0 | £400 | £0 | £400 | £0 |
| Income tax | £33,640 | £32,680 | £30,240 | |||
| Tax relief on £2,400 contribution: £480 relief at source + £960 reduction in tax / £2,400 = 60%. | ||||||
| Tax relief on additional £6,100 contribution: £1,220 relief at source + £2,440 further reduction in tax / £6,100 = 60%. | ||||||
As the table shows, Fred’s own pension contributions benefit from an effective rate of tax relief of up to 60%. The first 20% is available as relief at source. He claims the balance via self-assessment: 20% higher rate relief through extending the basic rate band, plus a 20% reduction in income tax as a percentage of the gross contributions through the return of the personal allowance.
This final 20% reduction works because amounts that were previously taxed at the higher rate are now covered by the personal allowance. This is a 40% reduction in the tax liability, but because the personal allowance is reclaimed at a rate of £1 for every £2 reduction in adjusted net income, the effective rate of reduction is 20%.
An alternative could be for Fred to contribute an extra £5,100 gross to a pension and make a gift aid donation of £800 to charity. The charity would benefit from a grossed up donation of £1,000 at an effective cost to Fred of just £400.
Bernadette Lewis is financial planning manager at Scottish Widows
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