Let’s turn our attention to income tax brackets (or bands). It is generally a good idea to know how much income tax you are paying. Three reasons come to mind. First, you know how much net income you have left to save but also to invest. That’s crucial if you want to take control of your personal finances. Budgeting based on gross income can be perilous because gross income is usually not the amount available for you to spend and may lead you to overestimate the available cash at your disposal for any given month. Taxes but also social contributions and other potential deductions (made by your employer for instance) might affect your take-home pay. Second, government spending becomes more interesting. When you know how much the government is taking, this might spur a sudden interest to see how your money is being spent. If you disagree with how the government spends, then you have a ballot box to complain. This might be a bit idealistic but if it even works for a fraction of the population, then that’s a win for democracy. Third, the tax bracket you fall into is also a helpful indication of how the government views you: the higher the tax bracket, the more income you are supposed to have, the richer you are in the eyes of the government and society.
In the United Kingdom (Scotland excluded), as of the time of this post, we have the following income tax bands:
For the sake of completeness, below are the tax bands for Scotland, which recently reformed the rates for various levels of taxable income:
For the sake of simplicity, we will mostly focus on the UK tax bands, therefore excluding Scotland. The principles we discuss are however generally applicable to Scotland (absolute numbers may vary due to different tax rates).
Turning our attention to the UK tax bands, everything is quite self-explanatory if you make less than £100,000. For instance, if you make £35,000 a year, we have the following breakdown: the first £11,850 are untaxed, and between £11,851 and £35,000, the portion of your income is taxed at a rate of 20%. As described in the table above, the first £11,850 are untaxed: this is your personal allowance, meaning the amount the government allows you to keep without contributing to society. Not that paying taxes is the only way to contribute.
The more income you make, the highest the rate at which your additional income is taxed. This is essentially how progressive tax systems are supposed to work (this alone is a debate for another time). This principle of progressivity applies virtually everywhere, and especially in western economies.
However, in the United Kingdom, there is a catch. If your income exceeds £100,000, then your personal allowance – the income amount that is not taxed – diminishes. For people earning more than £100,000, the personal allowance of £11,850 is reduced by £1 for every £2 earned. Therefore, when someone makes over £123,700, then there is no personal allowance and one is taxed from the first pound earned.
According to HMRC, if you withdraw the personal allowance in full, the following income tax bands apply in Scotland and the rest of the United Kingdom:
Excluding Scotland, the figures presented by HMRC are essentially a subtraction of the upper bound of a tax band minus the full amount of the personal allowance. For instance, for the higher rate in the UK (excluding Scotland), we have: 43,430 – 11,850 = 31,580.
This is definitely one way to look at it and the math does seem to check out. I, however, think this is misleading as it implies that the effective marginal tax rate is not increased, i.e. 40% or 45% would remain applicable because the underlying amount of taxable income is no longer the same.
In reality, the tapering of the allowance increases the marginal tax rate by approximately 20% because you are reducing the allowance by £1 for every £2 earned over £100,000. In other words, the tapering effectively adds 20p of tax on every pound earned over £100,000. This is in addition to the 40% tax rate that is applicable for income over £100,000 but under £150,000. Therefore, the marginal tax rate in the United Kingdom (excluding Scotland) is effectively 60% for the portion of the income subject to the tapering of the personal allowance as tax is now payable on previously tax-free income. We are far from the 40% tax rate, which is supposed to apply to income over £100,000 and under £150,000.
Not only this surpasses the 45% additional rate applicable to income over £150,000 but it also seems to top any income tax rate in Europe. Through a combination of local and national taxes, Sweden may reach close to 60%. France also amounts for a very high rate when one takes into social security contributions or special contributions on income over 250,000 euros.
Arguably, a 60% marginal tax rate dents the progressivity of the UK tax system. The tax rate is supposed to increase as the taxable amount increases. Here, a taxpayer will pay 60% on a portion of its income under £150,000 and then 45% on the income earned over £150,000. In my humble view, this is an anomaly. HM Treasury is unlikely to act as this would substantially reduce the amount of taxes collected.
Is there a way not to pay 60% on income over £100,000?
The most common piece of advice I hear is to sacrifice cash in one form another. The idea is to trade cash for non-taxable benefits (for example) so that the taxable income is brought back closer to £100,000 – where the tapering starts to bite – or even under £100,000. This is seen as a win-win scenario as your total remuneration remains the same but your taxable income decreases (and so is the portion of your income subject to the de facto 60% tax rate).
Subject to one exception, I don’t find this solution particularly enticing for two reasons. First, most benefits provided by the employer such as health and dental insurance are taxed. As those benefits are taxed, there is, in reality, no rebate of the personal allowance. Second, sacrificing cash disincentives the employee to make more money: you are trying to avoid the threshold by taking a step back – reducing your taxable income. A better option is to simply try to make more as quickly as possible to overcome the tapering of the allowance. Granted, this is not easy, especially in a country where pay rises have been sluggish. But it is really the only effective way long-term: pay the 60% effective tax rate and then make more to reach the 40% or 45% tax rate once you have overcome the full effects of the tapering of your personal allowance. It is difficult but not impossible. Gig economy and passive income streams are making it easier to generate additional sources of income that will allow you to get over the tapering of your personal allowance.
I mentioned earlier one exception where I think sacrificing cash makes sense, and that is pension contributions. Unless you are subject to the pension contribution tapering (another type of tapering to be discussed later), it makes sense to maximize pension contributions, especially if those are matched by your employer. Subject to your pension allowances, you would get tax relief at the full rate. Although recent reforms significantly curtailed the effectiveness of pension contributions for high earners, it remains one of the rare available ways to improve your tax position.
Key takeaways from this post:
- Due to the withdrawal of the personal allowance, you are paying a 60% tax rate on a portion of your taxable income over £100,000
- Pension contributions are most likely the only effective way to mitigate the effects in the long term;
- Sacrificing your salary only makes it so far, at some point you simply need to earn more to overcome the tapering as quickly (and painlessly) as possible.
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