When 60 is the new 45: entrepreneurs must manage tax liability

If you’re an entrepreneur, you may already know your tax liability just shot up by a third. This is because, for any earnings above £100,000, you get less tax relief. Your top tax rate therefore lunges from 45% to 60%. But there are ways you can address this. And there’s a broader point…

A 60% tax trap

How hard do you work?

Fancy working a little harder? Well, I’m afraid you might need to if your “highest” rate of income tax springs up from 45% to 60%.

Let’s explain how this works. Then we’ll talk about how to tackle it – this is where the hard work comes in.

And then I’ll talk about the role financial and tax planning plays for entrepreneurs – because we can do all that hard work for you.

But let’s get the facts straight first.

The main rates

• Personal allowance: No tax on earnings up to £12,570.
• Basic rate: 20% on earnings £12,571-£50,270.
• Higher rate: 40% on £50,271-£125,140.
• Additional rate: 45% on £125,140+.

If you’re in Scotland, you’ve seven bands, not four, and a top rate of 48%. But it’s broadly similar.

Anyway, we get to blame a Labour Chancellor for the next bit. Not Rachel Reeves – but Alistair Darling. From 2010, he introduced personal allowance tapering. This means your personal allowance drops by £1 for every £2 earned over £100,000 – until that personal allowance falls to zero.

So, for income earned between £100,000 and £125,140, you pay £40 in tax. Tapering means your personal allowance falls by £50 in every £100 earned, so £50 gets exposed to the 40% rate – which is £20.

Add the £40 and the £20 together and … well, 60 is the new 45.

Avoiding the trap

There’s a simple answer: use pension contributions as your shield.

If you pay earnings over the threshold into your pension, you can avoid the trap and gain the usual tax relief applied to pension contributions.

For example, let’s say your annual income is £125,000. You put £20,000 of it in your pension. The government gives you £5,000 pension tax relief – and this bumps it up to £25,000.

This is because higher-rate and additional-rate taxpayers can claim extra tax relief of a further 20% and 25% respectively.

Instantly, your income has fallen to £100,000 and you reclaim your personal allowance in full. This knocks off another £5,000 from your tax bill.

It’s complex stuff of course. But that’s why we’re here.

And another…

Another way of steering away from the 60% rate is contributing to charity. You can get full tax relief on contributions you make to registered charities.

As HMRC says, “You can pay less Income Tax by deducting the value of your donation from your total taxable income. Do this for the tax year (6 April to 5 April) in which you made the gift or sale to charity.”

The value of expertise

There’s a case to be made that financial planning is as important to the entrepreneurial journey as accounting and legal expertise.

After all, when you create and lead your own business, your financial needs and expectations evolve with your success. How to optimise your first big dividend? What should your future income stream look like? How do you manage debts and liabilities without diverting from the daily tasks at hand?

This is where planners earn their fees.

They can also be a useful, impartial sounding board. They’ll have a clear focus on helping you attain your business and personal goals, helping you make big decisions aligned to your long-term strategy.

A financial planner who understands profit and loss, balance sheets and managing business accounts should add considerable value. And – as work and leisure inevitable stray into each other – they’ll help you keep business and personal finances separate.

And they’ll help you manage your tax affairs effectively. They will advise where you can make tax savings and help you avoid paying too much tax. Like the 60% tax trap.

If you’re an entrepreneur without a financial planner in the tent, why not give us a call? We can explore ways of helping you accomplish your goals – without falling into life’s traps.

We’re available on hello@firstwealth.co.uk and 020 7467 2700.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.