For those of you earning over £100,000 this tax year, remember that for every £2 of income earned over £100,000 an individual loses £1 of their personal allowance until they have no allowance left.
This makes the effective rate of tax 60% on income between £100,000 and £120,000 for 2014/15. (40% tax on the £2 (80p) plus 40% tax on the lost £1 allowance (40p) = £1.20 tax on £2).
So when your income is over £120,000 all the personal allowance is lost as this is double the personal allowance.
The measure of £100,000 is the ‘adjusted net income’. Broadly, this is total taxable income less certain deductions e.g. gift aid donations and gross personal pension contributions.
You can get your adjusted net income back down below the £100,000 if you can make a lump sum pension contribution of a suitable size:
- Identify total income for personal allowance purposes i.e. adjusted net income
- Calculate excess over £100,000 limit
- Calculate contribution to reduce adjusted net income to £100,000
- Make the personal pension contribution in the tax year in which the personal allowance is lost.
Mr Savvy has income of £110,000 so has lost some of his personal allowance. A personal pension contribution of £8,000 net, £10,000 gross is made.
So, the contribution has the dual impact of increasing the amount of tax free income through the reclaimed allowance as well as pushing out the basic rate band.
For a resulting net spend of £4,000 Mr Savvy has reduced his tax bill by £6,000 and generated a £10,000 into his pension pot.
The contribution of £10,000 has saved £4,000 in tax and received relief in the pension of £2,000 – an effective rate of tax relief of 60%!