Receiving a bonus on top of a basic salary is obviously cause for celebration, especially if this is not a regular occurrence or relied upon.
However, one-off bonuses, or salaries that regularly contain a variable element because the nature of the job is commission or bonus-based can make calculating tax obligations more complex.
Having a good understanding of how much income tax and National Insurance you SHOULD be paying is important, especially in light of recent concerns raised around HMRC’s new ‘dynamic coding’ approach to PAYE codes, introduced in July.
A recent Financial Times report highlighted that the new system is leading to “significant and aggressive deductions”, that particularly fail to take account of the one-off nature of bonuses.
The new system often presumes that a month including a bonus payment is reflective of a consistent rise in income and has led to individuals being taxed as though they received that level of payment every month of the year.
The glitch has led to situations such as an employee receiving a one-off £2000 bonus in September being taxed at a level presuming their annual gross salary had risen by £24,000 annually.
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How Tax Obligations on Bonus Payments Work
For anyone who has recently received a bonus or expects to receive a bonus at some point over the tax year, how much tax should be expected to be paid on it?
Simply put, a bonus is considered as income in exactly the same way as a salary and goes towards the annual income your tax band is based on.
An employee earning £40,000 per annum as a basic salary, receiving a £20,000 annual bonus will pay income tax on earnings of £60,000.
- £45,000 is the threshold for the higher income tax rate of 40%, so the first £5000 of the bonus will be taxed at 20% and the remaining £15,000 at 40%.
- £5000*20% = £1000
- £15,000*40% = £6000
Total income tax payable on a £20,000 bonus (on top of a £40,000 salary) would be £7000.
How to Legally Shelter Bonus Payments from the Taxman
However, there several ways that bonus earners can save or invest their bonus which means they will essentially not pay any income tax on it, up to an annual ceiling.
In the UK everyone earning up to £150,000 per annum has an allowance of £40,000 per annum that can be paid into a pension product tax free.
For those earning over £150,000, the allowance drops by £1 for every £2 earned above £150,000. Unused portions of the allowance from the previous three years can also be rolled over.
That means that any bonus paid into a pension product will have the income tax paid on it returned by the government in the form of a top-up to the pension contribution equal to paid income tax.
The government also pays a 25% top-up to contributions of up to £4000 per annum made to a Lifetime ISA. Funds in a Lifetime ISA can be used to either make a deposit on a first property or withdrawn as cash from the age of 60.
This also means that bonus cash paid into a LISA becomes income tax free (+ a 5% bonus) for basic rate tax payers. Additional and higher rate income tax payers will effectively reduce their tax bill by 25%.
Those with an appetite for risk can also claim income tax relief on extra cash received in the form of a bonus by investing in a start-up or start-ups through the EIS and SEIS schemes.
These schemes were initiated to encourage private investment in promising young business ventures, or startups, and are very generous indeed, reflecting the high-risk nature of this type of investment.
However, investing through EIS or SEIS takes a huge chunk out of the capital actually being put on the line by the investor by allowing them to reclaim a whack of it back. This comes initially in the form of income tax credit and in further loss relief if the investment does not prove to be successful.
When investing through EIS, investors can claim income tax relief of 30% on investments in qualified young companies of up to an annual value of £1 million and no minimum level.
In the case of SEIS, which companies in their very initial stages qualify for, income tax relief of 50% can be claimed on the investment.
In the case of both EIS and SEIS investments, the remaining capital at risk also qualifies for 45% ‘loss relief’ against income tax if the investment is not successful.
This means that £10,000 invested in an EIS-qualified startup only actually puts £3850 of the investment at risk and £2750 in the case of a similar £10,000 SEIS investment.
A further bonus is that shares from an EIS or SEIS investment disposed of for a profit at least 3 years after the initial investment are not subject to Capital Gains Tax. If the company goes big, or just does reasonably well, that could be a massive tax break
If you’ve had any experience of using any of these products or anything else, please explain further in the comments.Last updated: October 20th, 2017