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What is marginal tax?

The percentage of tax you pay to HMRC depends on how much you earn. Whether you’re filing personal or business taxes, it’s important to understand the concept of marginal tax rate. Here’s how it might impact your business’s tax calculations.

Marginal tax explained

To answer the question of ‘what is marginal tax’, you first have to look at income tax. The amount of income tax owed in any given tax year depends on two primary factors:

  • The amount of income that falls into your personal allowance (PA)

  • The amount of remaining income within each tax band

For most business owners, the PA is currently £12,500. You don’t have to pay any tax on this amount. From there, the percentage of tax paid on earnings for the next pound earned is referred to as the ‘marginal rate’ of tax.

The marginal tax rate is designed as part of a progressive tax structure. It ensures that lower earners pay a reduced proportion of their income in taxes in comparison to higher earners. Anyone earning less than £12,500 doesn’t owe any taxes, while earnings over £150,000 pay a marginal rate of 45%.

Effective vs. marginal tax rates

As stated above, the marginal tax rate refers to the rate paid on the next pound of earnings. Another frequently used term is the ‘effective’ rate of tax. This refers to the concept that taxpayer earnings will be taxed further due to other allowances being removed when earnings increase. For example, the Child Benefit is one such allowance. When earnings reach a high enough threshold, the Child Benefit is withdrawn which effectively lowers income beyond the marginal rate.

When filing your business tax return, you’ll also need to know the total rate of tax. This is the full amount owed to HMRC. It’s written as a sum rather than a percentage, and it includes everything owed during the accounting period after allowances or credits have been factored in.

Marginal income tax rates

Different countries will have different marginal income tax rates. For example, within the United States, there are currently seven progressive bands ranging from 10% to 37%.

For the 2019/20 tax year in the UK, the marginal income tax rates were:

Tax Band

Taxable Income

Tax Rate

Personal Allowance

Up to £12,500

0%

Basic Rate

£12,501 to £50,000

20%

Higher Rate

£50,001 to £150,000

40%

Additional Rate

Over £150,000

45%

For example, if you earned exactly £150,000 during the last tax year, your marginal rate of tax would be 45% because if you earned one more pound, the tax rate is 45%. However, if you earned £149,999 your marginal tax rate would be 40% as one more pound would keep you in that same tax bracket.

There are further considerations that can increase marginal tax rate within the UK, with higher earnings incurring more than the 45% tax rate. When personal income reaches £100,000, your tax-free PA is withdrawn which adds up to an extra 20% tax on earnings between £100,000 and £123,000. With an extra 20% tax, your marginal tax rate on any income over £100,000 would be 60%.

Keep in mind these are simply illustrations, as tax rates change from year to year.

How to mitigate marginal tax

There are numerous ways to provide some marginal tax relief, such as restructuring your business income. A tax planning expert can help you examine options that might work. Some typical marginal tax relief calculations could include:

  • Transferring assets like dividend income to your spouse

  • Investing assets in ISA accounts

  • Operating as a limited company to manage payments

  • Leave cash in the business

  • Paying a salary to your partner

  • Exchanging salary income for non-cash benefits

  • Making additional contributions to a pension fund

  • Making charitable donations

These are just a few ways to bring your business taxable income below the £100,000, avoiding the highest marginal tax bracket.

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