The rate of tax you’ll pay on the next £1 you earn is known as the marginal rate of tax. Crucially, it is not always the same as the rate of tax you paid on your last £1 earned.
This difference can be key to identifying ways of saving tax as you pass through the various tax thresholds.
For example, if you earn £12,570, then the marginal rate of tax is 20% (19% in Scotland) as that is what you’ll pay on the next £1. If you earn £50,270 then the marginal rate is 40% (42% in Scotland).
But there are times when your marginal rate of tax may differ from the well-known tax rates. This is most commonly seen in those with an ‘adjusted net income’ over £100,000 as that is when the tax rate is actually more than the 40% higher rate of income tax (45% in Scotland).
This is because hitting the £100,000 adjusted net income figure triggers the reduction in other tax-efficient allowances, resulting in you paying more tax than the 40% higher rate or even the 45% additional rate that is paid on incomes over £125,140.
The income figure used to make these calculations is called the ‘adjusted net income’. This is your total taxable income adjusted for the gross amount of charitable donations made via Gift Aid and any personal pension contributions where your pension provider has already given you tax relief at the basic rate.
Note that any amounts you pay into the NHS Pension will already have reduced your taxable income and will therefore already be taken into account in the calculation.
Points when marginal rates may begin to soar
The following are examples of where earning an extra £1 of income will see a marginal rate of tax that exceeds the rate of tax you might expect (the rates under UK tax legislation are: 20%, 40% and 45% outside of Scotland and 19%, 20%, 21%, 42%, 45% and 48% in Scotland)
Personal allowance
Your tax-free personal allowance goes down by £1 for every £2 over £100,000 of adjusted net income and by the time you’ve reached £125,140 you lose the whole of your personal allowance. As soon as your adjusted net income exceeds £100,000, every extra pound of income you earn will have a marginal tax rate of 60% because not only will you have income tax at 40%, you also lose personal allowance meaning more income is taxed at 40% instead of 20%.
Loss of child benefit
From 6th April 2024, an individual parent’s income over £60,000 will result in a high-income child benefit charge, which gradually increases until you no longer get any child benefit when earning over £80,000. The high-income child benefit charge will never be more than the child benefit paid to you but results in an additional cost to higher earners, further increasing that marginal tax rate. So, again in this situation, if you have an adjusted net income of £60,000, claim child benefit, and then earn more money your tax rate is not the 40% you might expect but 40% plus the cost of the repaid child benefit.
Loss of tax-free childcare
Those households earning under £100,000 are entitled to tax-free childcare, where for every £8 you pay into the account, the government pays in £2. Once over £100,000 – even slightly – you are no longer eligible and lose access to the scheme which is a significant cost. This results in a 25% increase in your childcare costs compared to family not earning over £100,000.
Loss of free childcare hours
Hitting £100,00 means you also lose access to the 15 hours free weekly childcare for two-year-olds and 30 hours free weekly childcare for three-to-four-year-olds again resulting in extra costs if you earn more, pushing you over the £100,000 threshold.
Aside from impacts on your marginal rate of taxation, there are other times where earning more income may have other consequences for your tax bill.
Personal savings allowance
As a basic rate taxpayer, you get a £1,000 tax-free allowance on interest from savings. This goes down to £500 when you’re a higher rate taxpayer and £0 as an additional higher rate taxpayer. Therefore, any interest income not covered by the relevant tax-free allowance is taxable at the top end of your income tax band – if this changes because you earn more income then you may see an increased tax bill on your interest income.
Tax rate on dividends
The tax-free dividend allowance is £500 and any dividend income over this is taxed at different rates if you are a basic (8.75%), higher (33.75%) or additional rate (39.35%) taxpayer. Therefore, your income tax band doesn’t just affect the allowances above, but also the tax rates you pay on dividend income.
As you can see from the above information, your marginal tax rate may not be the rate of tax you would expect. The loss of your personal allowance and/or various benefits, and knock on effects on other taxes, may result in a significantly higher marginal tax rate.
Therefore, it is important to be aware of the potential consequences of earning more money – this is not to discourage doing extra work, and we appreciate that times are tough for a lot of people right now, but paying attention to your marginal rate of tax could help avoid incurring extra unexpected costs.