Changes to the personal income tax allowance

(21/06/10)

With the start of the 2010/11 tax year, individuals lost the automatic right to receive the basic personal allowance. Instead, the allowance will be gradually reduced for those with adjusted net income (ANI) above the income limit of £100,000 until it is completely eroded.

To calculate ANI, first an individual’s net income is adjusted to take into account specified deductions (such as trading losses and payments made gross to pension schemes). This net figure is then reduced by the grossed-up amount of Gift Aid contributions and pension contributions which have received tax relief at source. Finally, any relief for payments to trade unions or police organisations that had been deducted in calculating net income is added back in.

Reducing the personal allowance

The reduction in the personal allowance is made at the rate of £1 for every £2 by which ANI exceeds £100,000. With a basic personal allowance of £6,475 for 2010/11, this means that anyone with ANI of more than £112,950 will not be entitled to any of the basic allowance.

The withdrawal of the allowance means that some individuals earning between £100,001 and £112,950 will effectively be paying a very high marginal rate of 60% tax on the earnings between those sums.

Where HM Revenue & Customs (HMRC) expects a person’s ANI in 2010/11 to be more than £100,000, it will adjust the tax code accordingly. An individual’s actual personal allowance for the year will be established once the 2010/11 self-assessment Tax Return has been submitted.

To preserve entitlement to the full basic personal allowance, ANI must be below £100,000 in the tax year in question. There are various steps that can be taken to reduce ANI including:

Pension contributions

As long as income does not exceed £130,000, pension contributions can be made without limit and without being subject to the special annual allowance charge, which applies to certain contributions in excess of this amount, made prior to 6 April 2011. This opportunity is particularly beneficial as the contributions attract higher rate relief. Where income exceeds £130,000, complex rules apply but broadly contributions can typically be made to the higher of normal regular contributions or £20,000, before the special annual allowance charge bites.

Gifts to charity

ANI can also be reduced by increasing payments made to charity under the Gift Aid scheme. Arguably, a taxpayer may prefer income to go to a charity rather than HMRC.

Restricting income

In a family company situation, where one family member or spouse is paid considerably more than the other, it may be possible to change the split to preserve personal allowances. Care must be taken to ensure that you comply with the necessary legalities.

If you run your business through your own company, you might opt to keep your income below £100,000 by reducing salary and dividends and keeping surplus cash in the company. This may allow personal income to be spread into a less profitable year, or, if you are nearing your exit, enable income to be taken as capital on sale or liquidation.

Please note: the new Government is set to introduce further changes to the personal income tax allowance – see The Second Budget and your business for further details.