financial planning that works for you
Personal allowance: to be or not to be...
Whether it is nobler in the mind to suffer the slings and arrows of outrageous taxation – or to take arms against them by making a personal contribution or using salary sacrifice? That is the question that is exercising our mind as we speak to clients with incomes above the £100,000 level.
The basic personal allowance has been subject to an income threshold of £100,000 since 6 April 2010. This means that individuals have their personal allowance reduced by £1 for every £2 above the £100,000 threshold. For the 2011/12 tax year, the basic personal allowance is £7,475. Therefore, the maximum reduction applies at £114,950 and above this point, an individual has effectively lost all of their personal allowance.
‘Adjusted net income’ is defined in section 58 of the Income Tax Act 2007. It is calculated in a series of steps and is effectively net income less specified deductions (such as grossed-up gift aid contributions and grossed-up pension contributions that have received tax relief at source).
Using the current income tax rates, let’s look at the difference in income tax payable assuming adjusted net income of £100,000 against adjusted net income of £115,000:
As you can see there is £8,990 more tax to pay on the extra £15,000 income, which equates to a tax rate of 60% on the £15,000.
Payment of a personal pension contribution
The great news is that making a personal contribution to a personal pension arrangement, for example, can reduce an individual’s adjusted net income below the £100,000 threshold.
Assume a client has income of £115,000 in 2011/12 with no other pension contributions being paid.
A pension contribution of £12,000 net (£15,000 gross) will reduce the adjusted net income level to £100,000, thus allowing the client to benefit from the full personal allowance of £7,475.
In addition, higher rate tax relief on the pension contribution would amount to £3,000 (20% of the gross pension contribution of £15,000). The figures work out as follows:
The difference in net income is £6,010. It has effectively cost this amount to make a £15,000 gross pension contribution. The effective tax relief is therefore £8,990, or 60%.
But could the pension contribution be even more tax efficient?
As an alternative to making a personal contribution, you could use salary sacrifice to reduce your adjusted net income. In addition, your employer may be willing to add in some or all of their national insurance (NI) saving to boost the pension contribution still further.
This example assumes an employee is a higher rate taxpayer earning £115,000 a year and is willing to sacrifice £725 per month from their net income.
The difference in net income is £5,710. It has effectively cost this amount to generate a £17,070 gross pension contribution. The effective tax saving is therefore £11,360 or 66%.
These examples are based on our understanding of current taxation law and HM Revenue & Customs practice, which may change. The amounts shown are examples and aren’t guaranteed. The amount of tax relief investors will get depends on their financial circumstances.
© 2012 evolve wealth news teamBack