Annual allowance: tax charge: rate of tax charge: terms used
‘Reduced net income’
Section 23 Income Tax Act 2007
In broad terms reduced net income is the income on which an individual actually pays tax. This is their taxable income that is more than their personal tax allowance.
In legal terms ‘reduced net income’ is the amount found after step 3 of section 23 Income Tax Act (ITA) 2007. This is after the individual has:
- identified their total income
- deducted any reliefs allowed for under section 24 ITA 2007
- deducted any personal allowance they may have.
‘Reduced net income’ forms part of the ordinary Self Assessment calculation.
Reduced net income - the effect of contributions paid under Relief at Source (RAS)
How a pension contribution is paid can affect the amount of an individual’s ‘reduced net income’. If they pay their contributions using relief at source (RAS) it will not have been taken off their taxable income at the point of payment. Someone who has paid a contribution using RAS will have a higher ‘reduced net income’ than someone who has paid their contribution by another method.
However someone who makes a contribution using RAS will have an increased basic rate limit above which they start to pay higher rate tax. The higher rate limit, above which tax is payable at 45 per cent (50 per cent in the case of annual allowance charge calculations for 2011-12 and 2012-13) is increased in the same way if contributions are made using RAS. The effect is that the amount of the annual allowance charge paid is the same whichever method is used to make contribution.
PTM041000 explains the different methods of giving tax relief on member contributions.
Judy and Chris both have a salary of £140,000. Both pay £15,000 contributions to their pension schemes. However Judy belongs to her employer’s pension scheme, which uses the net pay arrangement. Chris belongs to a personal pension scheme that has to use RAS.
Because Judy makes her pension contribution using the net pay arrangement her ‘reduced net income’ is £125,000.
As Chris makes his contribution using relief at source his ‘reduced net income’ is £140,000.
Basic and higher rate limits
The basic rate limit is the point at which an individual starts to pay tax at the higher 40 per cent rate.
The higher rate limit is the point at which an individual starts to pay tax at the additional 45 per cent rate (previously 50 per cent).
Details of the point at which higher rate tax or additional rate tax starts for a tax year are published on the GOV.UK website.
Note – from tax year 2016-17 onwards, for an individual who is a Scottish taxpayer, the appropriate tax rates are replaced with the ‘Scottish main rates’ equivalent. In practice, this means the Scottish basic rate replaces basic rate, Scottish higher rate replaces higher rate and Scottish additional rate replaces additional rate. The points at which Scottish rates start for a tax year are described on the GOV.UK website.
Both the basic rate limit and the higher rate limit will be increased by the gross amount of any:
- contribution paid using RAS i.e. the net amount paid to the scheme plus the basic rate of relief that the scheme claims from HMRC
- Gift Aid donation
the individual has actually made in the tax year.
In example 1 above if the normal basic rate limit is £35,000 and the normal higher rate limit is £150,000, Judy’s basic rate limit is £35,000 and her higher rate limit is £150,000 but Chris’ basic rate limit is £50,000 and his higher rate limit £165,000.
Each year Linda makes a £48,000 net contribution to her personal pension scheme that uses RAS. This has a gross value for tax purposes of £60,000.
Linda also makes a donation of £2,000 to her favourite charity using Gift Aid. Gift Aid donations are also grossed up at the basic rate. The Gift Aid donation has a value for tax purposes of £2,500.
Linda’s basic and higher rate limits are increased by the total of the RAS contribution and Gift Aid donation. Linda’s basic and higher rate limits will be increased by £62,500.
So if the normal basic rate limit is £40,000 Linda’s basic rate limit becomes £102,500.
If the normal higher rate limit is £150,000 Linda’s higher rate limit becomes £212,500.