If I could have a budget wish, perhaps some simplification of the income tax system would be nice. Once upon a time it was relatively easy to do an income tax computation by hand, and for those with incomes over £250k that is still largely true. At the lower end however this is now significantly trickier.
At the lower end of the tax system we are trying to cope with lots of different reliefs. New for this year we have the ‘personal savings allowance’ which gives basic rate taxpayers £1,000 of interest free of tax. This is £500 if you are a higher rate payer and nil for additional rate payers. What we already had however was the 0% savings rate for interest income which applies on the first £5,000 of savings income (where savings is treated as the top slice of income). Now we have both!
Also new is the ‘dividend allowance’ of £5,000 per person. This does not change if you are a basic, higher or additional rate payer and provides an exemption from tax for the first £5,000 of dividends per person, per tax year. Coupled with this, the dividend rates have also now changed. Dividends at the basic rate are now taxed at 7.5%, at 32.5% for the higher rate and 38.1% at the additional rate. (Remember how I said savings were treated as the top slice of income? It’s actually the top slice unless there are dividends. And unless there are gains which are the top trump as far as this goes).
The Government’s announcement that it would support marriage through the tax system means that £1,000 of your personal allowance can be transferred to your spouse or civil partner. However, this will only be available and beneficial where one party has income of £10,000 or less and the other is a basic rate taxpayer.
What is the basic rate of tax in the UK?
An excellent question! And one to which you might cry out ‘20%’! Which is correct on a very strict interpretation of what the basic rate of income tax is. However, if you are paying basic rate income tax on employment income you will also be paying national insurance of 12% on the same income. So technically you might be paying 20% – in actual fact you are paying 32%. One of the biggest and most cost effective simplifications of the tax system that we could have would be merging NIC and income tax. But no Government will ever do this because then they would have to confess that the basic rate is actually 32%.
What is the highest rate of tax in the UK?
You would think this would be an easy question to answer. Officially of course the additional rate, where income is over £150,000, is 45%. Your marginal rate is the rate you pay on every additional £1 and this can be very much higher because of the complexities inbuilt into the system, mostly over the last ten years. You can pretty much pick a percentage and find someone who will be paying that marginal rate of tax.
The high income child benefit charge (HICBC) was introduced in 2013 to clawback child benefit from those couples where the higher earner earns in excess of £50,000. The child benefit is repaid as tax at 1% of the amount received for every £100 of income. By the time £60,000 is reached therefore, all of the child benefit will have been repaid as tax.
Ms Hubbard has seven children. Her annual child benefit is therefore £5,351. She earns £50,000 and after a particularly good year received a bonus of £10,000. On this she will pay 40% income tax and 2% national insurance, totalling £4,200. She will also suffer a clawback of £5,351 of child benefit. This gives her a marginal tax rate of 95.5% and £449 of her bonus to keep.
If pregnancy number seven had resulted in twins, Mrs Hubbard’s marginal rate would have been 110%.
Assume however her partner is Mr Prince (who is not the father of the children) who does the same job and received a £12,000 bonus. She lived with him throughout the tax year but they split up in May. In that case, she would not have any HICBC charge. This would fall on Mr Prince, even though it was a short term relationship and they were not his children. Her tax rate falls to 42% and Mr Prince pays at a marginal rate of 86.6% and gets to keep £1,609 of his bonus.
From 6 April 2017, residential landlords will no longer get full tax relief on their rental profits and by 6 April 2020 will receive only 20% relief (equivalent to the basic rate) on these. Which sounds, if not fair, then at least straight-forward. You might not be surprised to learn that this is not the case. Because of the way the calculation works it will be the gross rents which are treated as the income for computational purposes.
If previously a rental property has made a loss of £5,000 (imagine net rents of £15,000 after repair, maintenance and professional fees and interest of £20,000) and the taxpayer’s other income is £45,000 then the highest rate of tax will be a simple 40%. But from April 2020 income will be treated as £60,000 (ie £45,000 plus net rents of £15,000). Not only is tax now payable on an economic loss but in addition where child benefit applies, it will all be clawed back.
It’s 2021 and Ms Hubbard’s children are growing up so that child benefit is now only claimed for four of them at £3,214 per annum. She is still on a base salary of £50,000 and continues to rent out her buy-to-let property which she bought in 2007 on a 90% interest only mortgage. The net rents are £15,000 and interest on the loan per annum is £20,000. She is currently making a loss but is banking on property prices increasing in the long term.
From April 2020 she will pay additional tax of £2,000 per annum on her buy-to-let (£15,000 x 40% less £20,000 at 20%) even though she is making an economic loss. Plus because the full rents of £15,000 enter the computation her income for child benefit clawback purposes is £65,000 and so she suffers a HICBC of £3,214. This gives a total tax increase of £5,214 caused entirely by the way the 20% relief for interest is calculated.
A similar thing happens around the £100,000 to £122,000 threshold (increasing to £123,000 from 6 April 2017). If a taxpayer’s income is between these numbers then their personal allowance is withdrawn by £1 for every £2 of income, giving an effective rate of 60%. Child benefit will have been long gone at this income level but throw in a buy-to-let property and you get the same effect as noted above. That is, the gross rents will enter the computation and will push taxpayers into the 60% marginal rate bracket as well as paying tax on an economic loss.
The combination of all of these reliefs and clawbacks means that it’s very hard to answer the question ‘what rate of tax am I paying?’ with any certainty and some simplification would be very welcome.