Why is my personal tax allowance reduced?
As you work to build your financial security and stability, understanding your personal tax allowance and any changes to it is crucial. Your personal tax allowance is the amount of income you can earn each tax year before you have to start paying Income Tax. For most people, it increases each year to account for inflation and rising living costs. However, there are certain life events or circumstances that can actually reduce your personal tax allowance and increase the amount of tax you owe.
What Are Personal Tax Allowances?
Personal tax allowances refer to the amount of income you can earn each tax year before you start paying income tax. In the UK, most people are entitled to a standard personal allowance. For the 2020/21 tax year, the standard personal allowance is £12,500. If your income is below this threshold, you do not need to pay any income tax.
Once your income exceeds your personal allowance, you will pay income tax on the amount above the threshold. The income tax rates in the UK are:
1. Basic rate: 20% on income between £12,501 and £50,000
2. Higher rate: 40% on income between £50,001 and £150,000
3. Additional rate: 45% on income over £150,000
There are certain circumstances where your personal allowance may be reduced or eliminated:
* If your income is above £100,000, your personal allowance is reduced by £1 for every £2 above this amount. This means your allowance is reduced to zero if your income reaches £125,000.
* If you claim certain benefits like jobseeker’s allowance or tax credits, your personal allowance may be affected.
* If you have what HMRC calls ‘adjusted net income’ over £50,000 and claim child benefit, you may have to pay a high income child benefit charge to repay some or all of the benefit.
As you can see, understanding your personal tax allowances and the factors that can influence them is important to ensure you pay the proper amount of income tax each year. You should check with HMRC or a tax professional if you have any additional questions about your allowances or tax liability.
How Much Is the Standard Personal Tax Allowance?
The standard personal allowance for 2021-22 is £12,570. This is the amount of income you can receive before you start paying Income Tax. Your personal allowance may be reduced or withdrawn completely based on your income.
Income Thresholds That Reduce Your Personal Allowance
For every £2 of income above £100,000, your personal allowance will be reduced by £1. Once your income reaches £125,140, your personal allowance is reduced to zero. This means all your income above £125,140 is taxed at the higher rate of 40% or the additional rate of 45% if your income is over £150,000.
1. If your income is £105,000, your personal allowance is reduced by £2,500 to £10,070.
2. If your income is £120,000, your personal allowance is reduced by £10,000 to £2,570.
3. If your income is £130,000 or more, your personal allowance is reduced to zero.
The reduction in your personal allowance is calculated automatically by HMRC based on your taxable income. The amount of personal allowance you have left depends on your exact income level and circumstances. You can use the government’s Personal Allowance calculator to determine how much personal allowance you have based on your estimated annual income.
Exceptions That Do Not Reduce Your Personal Allowance
Certain income types are not included when calculating if your personal allowance should be reduced, such as:
* Dividends from shares
* Interest on savings
* Pension payments
* Maintenance payments from an ex-spouse or civil partner
So if your only income is from these sources, your personal allowance will not decrease no matter how much you earn. The rules around personal allowance reductions can seem complicated, but understanding how it may impact you can help ensure you pay the proper amount of taxes each year.
Why Would My Tax Allowance Be Reduced?
There are a few common reasons why your personal tax allowance may be reduced:
If your income exceeds £100,000 per year, your personal allowance will decrease by £1 for every £2 earned above this threshold. This means individuals with an income of £125,000 or more will have their personal allowance reduced to zero. The purpose of this is to require higher earners to pay more tax on their income.
Contributing to certain pension schemes, such as a personal pension or stakeholder pension, may reduce your personal allowance. For every £2 of pension contributions made, your personal allowance decreases by £1. The maximum reduction is £30,000, so if you contribute £60,000 or more to your pension in a given tax year, you will lose your entire personal allowance. The logic here is that the tax relief you receive on pension contributions acts as a kind of allowance, so your personal allowance is reduced to balance it out.
Gift Aid Donations
If you make charitable donations through Gift Aid, your personal allowance will decrease by the amount of basic rate tax the charity can claim on your donations. For example, if you donate £100 through Gift Aid, the charity can claim an extra £25 in basic rate tax from HMRC. Your personal allowance would then decrease by £25. As with the other reasons, this is meant to balance the tax relief provided by the Gift Aid scheme.
Marriage Allowance Transfer
If you transfer 10% of your personal allowance to your spouse or civil partner under the Marriage Allowance scheme, your own personal allowance will decrease by the amount transferred. The maximum that can be transferred is £1,260 for the 2023-24 tax year, so your personal allowance would drop by the same amount if transferring the maximum.
In summary, contributing too generously to your pension or charity, earning a high salary, or transferring your allowance to a partner may trigger a decrease in your personal tax allowance. Be aware of how these actions could impact your allowance and tax liability.
Your Income Exceeds £100,000
If your income exceeds £100,000 in the UK, your personal tax allowance will decrease. This is known as the ‘income tax taper’. For every £2 you earn over £100,000, your tax-free personal allowance reduces by £1. This means that once your income reaches £125,000, your personal allowance is reduced to zero.
The income tax taper was introduced in 2010 to ensure higher earners pay more income tax. Previously, all UK residents were entitled to the full personal allowance, regardless of income. The policy aims to make the tax system fairer by requiring higher earners to contribute more. However, it has been criticized as an effective tax increase that reduces the incentive for individuals to earn more.
How the Income Tax Taper Works
Your personal allowance entitles you to earn a certain amount of income each year tax-free. For the 2020-21 tax year, the standard personal allowance is £12,500. If your income exceeds £100,000, your personal allowance will decrease by £1 for every £2 you earn over this threshold. For example:
•If your income is £105,000, your personal allowance is reduced by £2,500 to £10,000.
•If your income is £110,000, your personal allowance is reduced by £5,000 to £7,500.
•If your income is £125,000 or more, your personal allowance is reduced to zero.
Any income above your reduced personal allowance is taxed at the basic rate of 20%, higher rate of 40% or additional rate of 45% depending on the level of your taxable income. The income tax taper only applies to your personal allowance – it does not reduce the thresholds for the higher or additional rates of income tax.
The income tax taper can increase your tax liability significantly once your income exceeds £100,000. However, there are certain tax planning strategies you can use to reduce its impact, such as increasing pension contributions or charitable donations. You should consider speaking to a tax advisor to explore ways of mitigating the effects of the income tax taper on your tax bill.
You Received Child Benefit
If your personal tax allowance has been reduced, it may be due to receiving Child Benefit payments. Child Benefit is a tax-free payment made to anyone responsible for raising a child. However, if you or your partner individually have an income over £50,000, your personal allowance will be reduced.
For every £1 you earn above £50,000, your personal allowance will be reduced by 50p. This is known as the ‘high income child benefit charge.’ The charge only applies to the higher earner in a household. If you and your partner both earn over £50,000, the charge will apply to the person with the highest income.
Calculating Your Adjusted Allowance
To calculate your adjusted personal allowance, you will first need to determine your income for the tax year. This includes earnings from employment, self-employment, property income, interest on savings, and dividends. Then, deduct £50,000 from your income. Divide the remaining amount by 2 to determine the reduction to your personal allowance.
For example, if your income is £55,000, deduct £50,000 which leaves £5,000. Divide £5,000 by 2 which is £2,500. Your personal allowance of £12,500 will be reduced by £2,500, leaving you with an adjusted personal allowance of £10,000. You will pay tax on any earnings above £10,000 at your normal tax rate.
The high-income child benefit charge only applies to the current tax year. Your personal allowance will return to the full amount the following tax year unless your income remains above the £50,000 threshold.
Options to Reduce the Charge
There are a few options you can consider to reduce or avoid the high income child benefit charge:
•Reduce your income below the £50,000 threshold by making pension contributions, charitable donations or by delaying when you draw your salary or dividends.
•Opt out of receiving Child Benefit payments. Although you will lose the benefit amount, your personal allowance will remain unchanged. Your child(ren) would still be entitled to certain benefits like free school meals based on your household income.
•Pay the charge to continue receiving Child Benefit. For some families, paying the charge in order to keep receiving Child Benefit payments at the full rate is financially beneficial. You will need to determine what option is right for your situation.
You Have Income From Rent
If you receive income from renting out a property you own, your personal tax allowance may be reduced. This is because the income you earn from rent is considered ‘unearned’ income by HMRC.
Unearned income includes:
* Income from savings, investments, dividends, and property rent
* Income that is not earned through employment or business
HMRC considers unearned income separately from earned income for taxation purposes. For every £2 of unearned income you receive over £100,000, your personal allowance is reduced by £1. This means that if you earn a high amount of unearned income from property rent, you may lose some of your tax-free personal allowance.
How Your Allowance is Reduced
Your personal allowance is reduced by £1 for every £2 of your unearned income over £100,000. For example:
* If your unearned income is £105,000, your personal allowance is reduced by £2,500 (£105,000 – £100,000 = £5,000/2 = £2,500)
* If your unearned income is £150,000, your personal allowance is reduced by £25,000 (£150,000 – £100,000 = £50,000/2 = £25,000)
The maximum reduction is £9,440, which would reduce your personal allowance to £0. Any unearned income over £181,000 is taxed at 20%.
How to Report Your Unearned Income
You must report your unearned income from property rent in your self-assessment tax return each year. Include the total amount of rent received, along with any allowable expenses. HMRC will use this information to calculate if your personal allowance needs to be reduced due to your level of unearned income.
Keeping good records of your rental income and expenses will help ensure your tax liability is calculated correctly. You may also want to consider ways to minimize the tax impact of your unearned income, such as by maximizing allowable deductions for property expenses. Speaking to an accountant can help provide guidance specific to your situation.
You Have Income From Trusts
If you receive income from one or more trusts, your personal tax allowance may be reduced. This is because for tax purposes, income from trusts is treated differently than income from employment or pensions.
When you receive income from a trust, HMRC considers this “unearned” income. As such, if your unearned income exceeds £100,000 in a tax year, your personal allowance will be reduced by £1 for every £2 over £100,000. This means that if you receive £114,000 in unearned income from trusts in a tax year, your personal allowance of £12,500 will be reduced by £7,000 to £5,500.
Any income you receive from trusts above £100,000 will be taxed at a higher rate than income within your personal allowance.The way your personal allowance is reduced depends on whether the trust income is distributed to you or accumulated in the trust on your behalf.
•Distributed trust income: If income is paid out directly to you, your personal allowance will be reduced in the tax year you receive the income distribution. This income is taxed at your marginal income tax rate.
•Accumulated trust income: If income is accumulated within the trust on your behalf, the value of the trust fund is deemed to be your income for tax purposes. Your personal allowance may be reduced for the tax year the income is accumulated, even though you do not receive an actual distribution. However, you are not taxed on the deemed income until the money is paid out to you.
In summary, receiving income from one or more trusts can impact your personal tax allowance and the amount of tax you pay. To understand your tax obligation fully, you should seek advice from a tax professional on the specific details of your trust income and allowances. They can help ensure your tax liability is calculated properly and determine if any exemptions or reliefs may apply in your situation.
You Have Foreign Income
If you have income from outside the UK, it can affect your personal tax allowance. Your personal tax allowance is the amount of income you can earn each year before paying income tax. For the 2020-21 tax year, the standard personal allowance is £12,500. However, if you have foreign income, your personal allowance may be reduced.
Non-UK Income Exceeds £2,000
If your non-UK income exceeds £2,000 in the tax year, your personal allowance will be reduced by £1 for every £2 of income over £2,000. For example, if your non-UK income is £10,000, your personal allowance would be reduced by £4,000 (£10,000 – £2,000 = £8,000. £8,000/2 = £4,000). Your personal allowance would be £12,500 – £4,000 = £8,500.
Claim Foreign Tax Credit Relief
You may be able to claim Foreign Tax Credit Relief if you’ve paid foreign tax on your overseas income. The foreign tax you’ve paid can be deducted from your UK tax liability. However, the amount of foreign tax credit relief you can claim cannot exceed your UK tax liability on the same income. Claiming this relief can help reduce your overall tax burden.
Report Foreign Income and Gains
You must report your foreign income and any chargeable gains from the disposal of foreign assets to HM Revenue and Customs. This includes income from employment, self-employment, pensions, property, and investments. You must declare this income on your Self Assessment tax return. Failing to report foreign income and gains can result in penalties.
Consider Domicile Status
Your domicile status can also affect how your foreign income is taxed. If you are UK domiciled, you are subject to UK tax on your worldwide income. If you are non-UK domiciled, you are taxed differently and can claim the remittance basis. The remittance basis means you are only taxed on foreign income and gains remitted to the UK. Your domicile status depends on your long term residence and intentions.
In summary, having foreign income over £2,000 or certain types of non-UK income and gains can result in a reduction of your personal allowance and therefore a higher income tax bill. However, by taking appropriate actions, you may be able to reduce your tax liability. You should keep records of all foreign income and gains, and report them accurately to HMRC.
Why Is My Personal Tax Allowance Reduced FAQs
Your personal tax allowance is the amount of income you can receive each tax year before paying tax. However, there are certain circumstances that may reduce your personal tax allowance, resulting in you paying tax on more of your income.
Marriage or civil partnership
If you marry or enter into a civil partnership, your personal tax allowance may be reduced. This is known as the ‘marriage allowance transfer’. You can transfer £1,250 of your personal tax allowance to your spouse or civil partner, which will reduce your own tax allowance by the same amount. This can only be done if one spouse or civil partner has an income below their personal tax allowance, while the other spouse’s income is above their personal tax allowance.
Adjusted net income over £100,000
If your adjusted net income is over £100,000, your personal tax allowance will be reduced by £1 for every £2 of income over £100,000. This means that if your income is £125,000 or more, your personal tax allowance will be reduced to zero. Any income you earn above £125,000 will therefore be taxed at the higher or additional rate of tax.
Contributing to a pension scheme, such as a workplace or personal pension, can also reduce your personal tax allowance. For every £2 of pension contributions you make, your personal tax allowance is reduced by £1. However, pension contributions are tax deductible, so you will receive tax relief on them. The reduction in your personal tax allowance is to limit the amount of tax relief higher earners can receive on pension contributions.
Gift aid donations
If you make gift aid donations to charities, these can also reduce your personal tax allowance. For every £1 you donate through gift aid, your personal tax allowance is reduced by 25p. However, you will have received tax relief on your gift aid donations at the basic rate of tax. The reduction in your personal tax allowance prevents higher and additional rate taxpayers from receiving excess tax relief on gift aided donations.
In summary, getting married, earning over £100,000, making pension contributions, and donating to charity through gift aid are all circumstances that may decrease your personal tax allowance, requiring you to pay income tax on more of your earnings. However, there are also tax benefits to some of these activities, such as tax relief on pension contributions and gift aid donations. It is best to fully understand how these activities may impact your tax liability before proceeding.
As you have seen, there are several reasons why your personal tax allowance may be reduced. The primary causes relate to your income level and certain life events like marriage or divorce. While it can be frustrating to have less take-home pay, reducing allowances is an important part of the UK’s progressive tax system. The government uses your contributions to fund important programs and services for citizens.
If your allowance has dropped and you have questions or concerns, consider speaking with a tax professional. They can review your specific situation, ensure your allowances and rates are correct, and suggest any steps you need to take. You may also want to revisit your tax code and see if there are any errors. Making sure you fully understand the reasons behind any changes to your allowance will help you plan your finances accordingly and avoid unwanted surprises at tax time.