Many employees and business owners have welcomed higher earnings over the past few years. However, for a growing number of taxpayers, a larger salary does not necessarily mean significantly more money in their pocket.
The reason is a process known as fiscal drag.
Although tax rates have remained broadly unchanged, personal tax thresholds have been frozen for several years. As wages increase, more people are finding themselves paying tax at higher rates, even if their pay has only kept pace with inflation.
This means that someone who previously paid only the basic rate of Income Tax may now be paying tax at 40%, while others may have moved into the additional rate band. The effect can be surprisingly expensive, particularly when combined with the loss of valuable tax allowances.
Moving into a higher tax band can affect far more than your Income Tax bill. It may reduce your Personal Savings Allowance, increase the rate of Capital Gains Tax payable on certain assets, and expose you to the High Income Child Benefit Charge. Individuals with income above £100,000 may also begin to lose their Personal Allowance, creating an effective marginal tax rate of 60% on part of their income.
Business owners should also remember that higher personal income may affect the most tax-efficient way of extracting profits from their company. The balance between salary, dividends and pension contributions should be reviewed regularly rather than simply carried forward from previous years.
Fortunately, there are often legitimate ways to reduce your taxable income. Pension contributions remain one of the most effective planning opportunities, while Gift Aid donations can also extend the basic rate tax band. Business owners may benefit from reviewing the timing of dividends, bonuses or other income where flexibility exists.
The important point is not to assume that a higher salary automatically leaves you better off after tax. A modest increase in income can sometimes trigger unexpected tax consequences that outweigh much of the additional earnings.
If your income has increased recently, now is an excellent time to review your overall tax position. Early planning can often reduce your tax liability while ensuring you continue to make the most of the reliefs and allowances available.
If you would like us to review your personal tax position or discuss ways to improve your tax efficiency, please contact us. We will be pleased to help you identify opportunities to minimise your tax bill while remaining fully compliant with HMRC's rules.
