No, the headline that an acquaintance of ours has recently received an additional tax bill of £5,000 for earning over £125,000 in tax year 2020/21 is not a joke. The person in question was expecting a tax refund but now faces an additional tax bill.
This is because he did not know about the reduced or tapering of the personal allowance when you have earned income of more than £100,000pa.
For every £2 you earn above £100,000 your personal allowance is reduced by £1.
Tax Year 2020/2021
Personal Allowance £12,500 meaning:
If you earned £125,000 or more, for every £2 earned above £100,000, the allowance is reduced by £1. In the above case, £125,000 earnings meaning £25,000 over and reduced on £2 for £1 = £12,500 reduced i.e., no personal allowance left.
Our said acquaintance had already paid 40% income tax on this but with the loss of £12,500 allowance it means another £12,500 of income is taxed at 40% = £5k additional tax bill.
In this case, the equivalent tax rate on that additional £25,000 earned is over 60% (40% i.e.. £10,000 paid on the £25,000 excess plus the additional £5,000 tax bill for loss of allowance meaning £15,000 tax paid on that £25,000 income i.e., 60% equivalent tax rate.
Current Tax Year 2021/2022
Personal Allowance £12,570 meaning:
If you earned £125,140 or more, for every £2 earned above £100,000, the allowance is reduced by £1. Meaning, for £125,570 earnings i.e., £25,570 over and reduced on £2 for £1 = £12,570 reduced i.e., no personal allowance left and an additional tax bill likely of £5,028 (£12,570 X 40%).
Protect Your Personal Allowance
A very easy way to protect your personal allowance if you earn over £100,000 is to make a pension contribution to reduce your equivalent earnings e.g. If you earn £125,570, make private personal contributions to pensions of £25,570 gross (so it does not cost you £25,570 but actually a £20,456 net payment) and you will not only protect your full personal allowance, you have also had 20% basic tax relief added at source of £5,114 plus you are due a tax refund of the other 20% (making it 40% tax relief) of another £5,114.
In summary, by writing a cheque for £20,456 you have just saved yourself a £5,028 tax bill by not losing your whole personal allowance, but you have also had tax relief at source of £5,114 plus a further tax refund of £5,114. In real terms you have saved over £15k for a cost of £20,456 and ended up with £25,570 extra in a pension fund.
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