Contractors can avoid the 60% tax rate

From 6th April 2010, an effective income tax rate of 60 per cent will apply to freelancers earning over £100,000 a year.

Put another way, over 700,000 high earners will lose thousands of pounds to HM Revenue & Customs each year as personal allowance changes bite for the first time.

Background

The changes were announced in last year's Budget and sent shock waves through a large swathe of the population. Everyone from GPs and head teachers to a large number of contractors realised they would be hit by an effective rate of income tax of 60%.

Under the new rules, anyone earning over £100,000 will lose their right to the full £7,475 personal allowance. HMRC will claw this back via a reduction of 50p in every £1 that you earn over a new £100,000 threshold.

Your earnings

By the time you earn £114,950, your personal allowance is completely removed. Based on this, the marginal tax on earnings between £100,000 and £114,950 will be at the once unimaginable rate of 60% . For most higher earning contractors, this will mean that each year you will miss out on thousands of pounds of tax free income that is currently protected by the nil rate income tax band.

Here is an example of how the income tax differs for contractors earning £100,000 and £115,000:

£100,000 income
£7,475 personal allowance taxed at 0%
£35,000 taxed at 20% = £7,000
£57,525 taxed at 40% = £23,010
Total tax = £30,010

£115,000 income
£0 personal allowance taxed at 0%
£35,000 taxed at 20% = £7,000
£80,000 taxed at 40% = £32,000
Total tax = £39,000

This means you are liable for £8,990 tax on the £15,000 extra income which equates to 60% tax.

Forewarned is forearmed

As many of our contractor clients have asked - yes - you can prevent this 60% tax take on your earnings. You can even gain 69% tax relief!

The way to completely avoid this 60% tax is to ensure you fall below the new threshold. This can be achieved via a pension contribution made personally from your own bank account or, even more effectively, via an employer contribution.

Umbrella company worker?

If you operate via an umbrella company then you may be able to access a group pension scheme and use a salary sacrifice scheme in order to save the income tax. Salary sacrifice works because the umbrella contributes directly to the scheme on your behalf, taking out contributions from your gross earnings, so enabling you to reduce your income under the all important £100,000 limit. Because you also save the employer's and employee's National Insurance, an effective rate of tax relief of 68% applies!

IR35-caught 'Ltd'?

If you contract through a one-person limited company and are caught by IR35 a pension contribution is allowable outside of the 5% maximum expenses figure. Savings via salary sacrifice are again effectively 69% because you also save the employers and employees NI that would otherwise be due.

'Ltd' outside IR35?

Contracting through a one-person limited company outside IR35 means you may consider drawing a lower dividend and retaining profit within your company. Sadly corporate savings rates are pitifully low but, again, the company can contribute to a pension on your behalf to get this money growing properly for your future. This is a 'dividend sacrifice' to minimise your income tax while building a retirement fund for your future.

With just two weeks to go before the new thresholds come into force, it is essential that contractors make use of any available tax saving measures, and we are on hand to help!

Tony Harris, managing director of ContractorMoney, an independent financial advisor to IT contractors. (Figures updated 2011)