Marginal Tax Rates

What rate of tax would you pay on an additional £1 of earnings? If your annual income is between £41,865 and £150,000 you may think the tax rate would be 40%, but the peculiarities of the UK tax system mean you could pay much more.

To start with earned income above the 40% threshold carries a national insurance charge (NICs) of 2% so for every £1 you earn above £41,865 (for 2014/15) you will pay 42% in tax and NICs.

Child benefit is withdrawn from the highest earner in the family at the rate of 1% of the benefit for each £100 of income exceeding £50,000 per year. This translates into an effective marginal tax rate of 60% on income between £50,000 and £60,000.

When your income exceeds £100,000 your personal allowance is withdrawn at the rate of £1 for every £2 of income above £100,000. This is an effective tax rate of 62% including NICs.

From 6 April 2015 married couples will be able to transfer up to 10% of their personal allowance between them. This will allow up to £1,050 of the allowance to be transferred from the person who earns less than £10,500, to their spouse who earns up to the 40% threshold. Thus £1 of additional income that takes you over the 40% threshold will mean you lose the whole of that transferable allowance - an infinite marginal tax rate.

If you are able to control the level of your taxable income, perhaps because you run your own business, it makes sense to adjust your income to avoid those high marginal tax rates. Perhaps you could employ other members of your family, or take them into business with you as partners, to spread the business income.

Payments of pension contributions and Gift Aid donations can stretch your 40% threshold, so the higher earner in the family should making those charitable donations and pay pension contributions. We can help you plan to avoid the highest tax rates and make the best use of all allowances available.

How Gift Aid Works

There has been a lot of coverage in the press recently about tax relief for charitable donations.

When you make a donation to a charity or to a community amateur sports club you can make a declaration that your donation is made under Gift Aid. This declaration can be made in writing, online or over the phone, but in all cases it should include your name and address details, the name of the recipient charity, and a statement that you have paid sufficient UK tax to cover the 20% tax the charity will reclaim from the Tax Office.

Say you make a donation of £1,000 to a charity, and make a Gift Aid declaration for that gift. This results in a gift of £1,250 in the charity's hands as they can reclaim basic rate tax (20%) on the gross equivalent of the gift. In this example, 20/80 x £1,000 = £250.

You have to declare with your gift aid declaration that you have paid at least £250 in UK income tax or capital gains tax in the tax year in which you make the gift.

If you pay tax at 40% or 50%, the thresholds at which those higher rates are imposed are extended by the gross value of your gift, which gives you additional tax relief for your gift. For example, the 40% threshold is currently £34,370, so if you make donations under gift aid that total £1,000, these are treated as gross gifts of £1,250. Your 40% threshold is extended to £35,620, saving you 20% tax on £1,250 = £250. So overall it would have cost you £750 for the charity to receive £1,250.

It is not possible to completely eliminate your tax bill by making donations under gift aid. Such gifts would only reduce your tax bill to 20%.