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Removal of personal allowance

From the beginning of the 2010/11 tax year individuals with ‘net adjusted income’ in excess of £100,000 had their personal allowance reduced.

This reduction will be at a rate of £1 for every £2 of income over £100,000. Based on the personal allowance, this means that any person with income over £122,000 will lose their full personal allowance applying for the 2016/17 tax year.

When working out taxation of income, you start with the personal allowance, then apply tax at the basic-rate band and then tax at the higher-rate band. If the personal allowance is removed because the client’s net adjusted income is £122,000 or above, this effectively adds to the individual’s tax burden..The client now has no personal allowance and so is taxed on the £11,000, which was their personal allowance, at a rate of 20%. Additionally this will mean that a further £11,000 will be taxed in the clients higher rate tax band.

Example 1a - With personal allowance 
Income - £122,000
£11,000 – No tax
£32,000 – 20% tax equates to £6,400
£79,000 – 40% tax equates to £31,600
Total tax - £38,000

Example 1b – Without personal allowance 
Income - £122,000
£32,000 - 20% tax equates to £6,400
£90,000 – 40% tax equates to £36,000 (additional £11,000 now in this tax bracket)
Total tax - £42,400

So the removal of personal allowance has increased the amount to tax paid by £4,400.

If the client has an income in excess of £122,000 and still wishes to make personal pension contributions to reduce their income below the £100,000 threshold, this will produce a tax saving on what would have been paid if this course of action had not been taken.

The following illustrates the impact of paying a gross pension contribution of £22,000 for an individual with net adjusted income of £122,000.

Net adjusted income £122,000   Income of £122,000, pension contribution of £22,000  
40% tax on all income over £32,000   40% tax on all income over £32,000 plus the personal allowance  arrow The earnings subject to 40% tax have now reduced by £11,000 and therefore the client will only be paying basic-rate tax on this amount and effectively saving 20%.
20% tax on first £32,000   20% tax on next £32,000  arrow Previous basic rate tax band which has now been raised due to the application of the personal allowance.
  Personal allowance £11,000  

 

Net adjusted income is defined in section 58 of the Income Taxes Act 2007. Broadly it is the total income on which an individual is liable for tax, less the gross amount of any personal pension contributions, or third party contributions. However, remember that this is not the calculation for the actual payment of income tax and National Insurance (NI), and the full income before removal of the pension contribution will be subject to full tax and NI.

Example – Pension contribution - £22,000
Income - £122,000
£11,000 – No tax
£54,000 – 20% tax equates to £10,800 (Person contribution extends the basic rate tax band)
£57,000 – 40% tax equates to £22,800
Total tax - £33,600

Please note that in some circumstances, levels of annual allowance available for pension contributions may be restricted for high earners. Please read our article on tapered annual allowance - Tapered annual allowance.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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