Contractors' Questions: How to handle personal allowance clawback on adjusted net income over £100,000 via an umbrella company?

Contractor’s Question: I earned over £100,000 last year but was unaware that the personal allowance is clawed back by £1 for every £2 of adjusted net income above £100,000.

The upshot is I was left with a £4,000 tax bill following my submission of a tax return. I have asked my umbrella company if I can pay into my ‘Nest’ pension an additional payment using their payroll, i.e. from source - as this would be tax efficient, wouldn’t it?

But they have fixed contribution rates and they also do not allow additional voluntary payments. Does that sound right? What do contractors do in similar situations?

Expert’s Answer: This is a good question as it raises an issue that does affect a lot of contractors, mostly those that are now working inside IR35 contracts through umbrellas or agencies.

If you have for many years operated through a limited company and manged your income levels with low salary and dividends, then this is an issue you are likely to be caught off guard about, and absolutely should be aware of so you don’t get a nasty surprise from the taxman.

What is the personal allowance?

Let’s start with the personal allowance.

The personal ‘tax-free’ allowance is the first amount of all income an individual can have without any tax liability to HMRC .

This allowance has been stubbornly frozen for some time and remains at £12,570 for the 2024-25 tax year.

When was the personal allowance clawed back?

But since 2010 a new reduced personal allowance was introduced; this means that, as you say, for every £2 of net adjusted income over £100,000 your allowance is reduced by £1. If you earn over £125,140 your personal allowance will be reduced to zero. You will still have the same basic rate threshold at 20% so the income proportion that would normally be zero (£12,570) gets pushed into your highest rate threshold. The bottom line is -- every £1 is taxed.

The loss of the personal allowance has increased the tax burden by £5,028 which is £12,570 taxed at the now rate of 40% -- instead of being zero.

Here’s a table summarising the impact of the 2010 announcement on annual income of £125, 140:

What is adjusted net income?

Net adjusted income is the total income received before any personal allowances or reliefs are applied. To work out your “net income” you would include things like:

• Earned income, salary, bonuses, overtime and any other benefits.
• Profits from self-employed income.
• Pension income.
• State benefits.
• Savings interest or investment income.
• Rental income.
• Dividends.

To work out your adjusted net income, take the total sum of all income, and then subtract any reliefs available to you, such as:

• Any trading losses -- for example trade loss or property loss relief.
• Charitable donations.
• Pension contributions.

The total you’re left with is your adjusted net income, which if you can reduce below £125,140 will restore some of your allowance and if you can reduce to under £100,000, will fully restore your allowance.

Using pension to reduce your net adjusted income: two options

There are two ways to pay into a pension if you are working via an umbrella or agency which can help with your adjusted income or reduce your overall income.

1. Salary sacrifice

If your umbrella offers this option, this is a way for you to exchange part of your salary in an agreement between you and the umbrella towards pension contributions.

You would agree to forego an amount of reduction to your income that would be equal to a pension contribution. If your salaried contract income is £125,140 you could choose to sacrifice £25,140 across the year towards pension contributions -- and your adjusted income would then be £100,000 plus £25,140 of gross employer contributions.

This is a very simple and crude way of explaining it! Salary sacrifice has many benefits and disadvantages that need to be considered or talked through with your adviser.

Salary sacrifice is also a formal agreement, therefore careful consideration is a must before entering into such an agreement.

Be aware, not all umbrella companies offer salary-sacrifice. But it does have the added bonus of reducing national insurance liabilities too.

2. Relief at source pension contributions

‘Relief at source’ is a method of making personal pension contributions to a personal or employer pension from income that has already been taxed. You, as the individual, would make a contribution personally or via deduction from net wages and the pension provider would add your basic rate tax relief to the pension -- i.e. you pay in £100 to a pension and the provider will add a further £25 of contribution, which is your tax relief. You can then take the total gross contribution from your net income to calculate your adjusted net income.

There are so many things that need to be considered when it comes to utilising pensions. The ways you fund; your available allowances, tax implications, the right pension, costs, death benefits, and investment risk.

If you were just asking ‘Would it be tax efficient to pay into a pension?’, I would answer this with ‘All pension contributions are tax efficient, as a contribution no matter how you elect to fund, as they provide tax relief at your highest rate of tax.’ Of course, the amount you contribute, the way its funded and the impact it can have depends a lot on your personal circumstances.

Considering umbrellas and agencies -- quasi-employers

As the final part of your question, an umbrella or agency for a contractor is merely an intermediary (of sorts) between you and your end-client; they are a means for you to be paid. We can’t really consider them to be your ‘employer’ in the truest sense of the word. And ‘auto enrolment’ pension rules don’t distinguish so umbrellas fall into the circumstance of needing to fulfil their duties under these rules.

The pension schemes they will typically use as a result, such a NEST, are utilised to make them compliant rather than to offer you a means to save effectively for your retirement. In my experience, it’s not likely to be a flexible enough offering nor will the umbrella have the appetite to offer you a variety of funding options for their standard group pension.

Finally another two options (one could have saved that big HMRC bill…)

If you want to plan effectively and efficiently for your future and make some sound tax planning, then you would likely need to do this in two ways -- you would either undertake your own research and make necessary retirement saving arrangements and decisions yourself, or you might employ the services of a financial adviser like myself to help you manage these affairs more effectively.

You might think that paying for a professional adviser is expensive or not value, but financial advice could have reduced that additional tax bill you got of £4,000 -- or we may have been able to negate it altogether.

In conclusion, pensions are a very useful tool for reducing tax when utilised in the right ways, and if you aren’t sure how best to do this then financial advice will absolutely save you time and money, plus build you up a healthy nest egg for the future. Good luck, and reach out if you think I can help!

The expert was Angela James, founder of financial advisory Yolo Wealth.

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The value of pensions and the income they produce can fall as well as rise. You may get back less that you invested

Tax treatment varies according to individual circumstances and is subject to change

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