Overcoming the 60% tax trap

The new headline 50% tax rate has been well publicised - From 2010/2011, a 50% rate of tax will apply to individuals with taxable income in excess of a higher rate limit of £150,000 per annum.

However, not quite such a headline grabber is the fact that in addition to increased rates of income tax for high earners, those with an adjusted net income in excess of a £100,000 high income limit will see their basic personal allowance reduced or removed entirely from April 2010.

There will be a loss of £1 in personal allowance for every £2 of income earned over £100,000. The personal allowance will be lost when earnings equal £112,950 (the personal allowance for 2010/2011 will be £6,4750)giving an effective 60% tax rate.

Adjusted net income can essentially be defined as taxable income reduced by specified deductions e.g. such as trading losses and payments made gross to pension schemes, as well as grossed-up gift aid and pension contributions which have received tax relief at source.

This means that provided an individuals adjusted net income is below or equal to the £100,000 limit, they will continue to be entitled to the full amount of the basic personal allowance.


Example

The following example considers the tax relief available if the pension contribution is paid in 2010/2011.

The personal allowance in 2010/2011 will be £6,475 and the basic rate tax band £37,400.

Mr X is earning £112,950, and he makes a pension contribution of £12,950.

If Mr X has earnings of £112,950 - and no other income - in 2010/2011 he would not only be liable to 40% tax on the top £12,950 slice of his salary, but would also lose all £6,475 of his personal allowance (£1 for every £2 above £100,000).

This amount of £6,475 would be liable to 40% tax, meaning the overall tax liability on his top £12,950 slice of salary is effectively £7,770, or 60%.

If Mr X made a personal pension contribution of £12,950 gross, his adjusted net income would be reduced to £100,000.

Not only would this reduce his higher rate tax liability, but it also means that he would retain his full personal allowance.

Mr Xs effective tax relief on the £12,950 pension contribution is £7,700 which equates to 60%.