What is the Marginal Tax Rate?
The marginal tax rate refers to the percentage of tax paid on the next pound of income earned after accounting for the tax free personal allowance.
Understanding the marginal tax rate is particularly important for self employed individuals and company owners to help accurately calculate how much income tax you owe and strategise ways to reduce tax liability.
Marginal Tax Rate explained
Income tax is based on two primary factors: the amount of income that falls into your personal allowance and the amount of remaining income that falls within each tax band.
The tax free personal allowance is an amount of income you are allowed to earn without paying any tax.
In the UK the personal allowance is currently expected to be £12,570 until April 2026. Income earned above the personal allowance is taxed at different rates depending on the tax band it falls into.
The marginal tax rate is the rate of tax paid on the next pound earned beyond the personal allowance.
Progressive tax system and the Marginal Tax Rate
The marginal tax rate is designed as part of a progressive tax system. A progressive tax system is structured so that those who earn less are taxed less, while those who earn more are taxed more.
In the UK (apart from Scotland) the marginal tax rate ranges from 0% for those who earn less than the personal allowance to 45% for additional rate taxpayers.
Effective vs. Marginal Tax Rates
The marginal tax rate is often confused with the effective tax rate. While the marginal tax rate refers to the amount of tax paid on the next pound earned the effective tax rate refers to the overall percentage of income that is taxed.
The effective tax rate is often higher than the marginal tax rate for high earners because certain benefits and allowances are gradually withdrawn as income increases over £100,000.
What are the Income Tax Rates and Bands?
There are four tax bands with each having a different income tax rate which gradually goes up.
The tax bands and income tax rates from April 2023 to April 2024 are:
| Income Tax Band | Taxable income | Tax rate |
|---|---|---|
| Personal Allowance | Up to £12,570 | 0% |
| Basic rate tax | £12,571 to £50,270 | 20% |
| Higher rate tax | £50,271 to £125,140 | 40% |
| Additional rate tax | over £125,140 | 45% |
Different income tax rates and tax bands are applied in Scotland which you can find here.
The UK government can change income tax rates and bands so keeping up to date with announcements in the next budget is recommended.
Can I reduce the Marginal Tax Rate
There are many ways to reduce your marginal tax rate. Some common methods include:
- Transferring assets to your spouse: If your spouse is in a lower tax bracket, transferring assets to them can reduce your overall tax liability.
- Investing in ISA accounts: ISAs are tax free savings accounts. By putting money into these accounts you can reduce your taxable income.
- Operating as a limited company: There may be tax benefits to operating as a limited company, as you can manage payments more effectively.
- Paying a salary to your partner: If your partner is in a lower tax bracket, paying them a salary can reduce your overall tax bill.
- Making additional contributions to a pension fund: Pension contributions are tax deductible, so by contributing more to your pension fund, you can lower your taxable income.
- Making charitable donations: Donating to charity is tax deductible and can reduce your taxable income.
Understanding the Total Rate of Tax
The total rate of tax is the full amount of tax you owe to HMRC. It is written as a sum rather than a percentage and includes everything you owe for the accounting period after allowances and credits have been factored in.
Tax Planning to lower the Marginal Rate of Tax
The most effective way to reduce your marginal tax rate is through tax planning.
A tax planner can help you examine your options and come up with strategies that work best for your business or you as an individual.
Tax implications for individuals, sole traders and limited companies can vary significantly so it’s important to consider them carefully before making decisions based on reducing income tax.
A tax advisor can help you explore the benefits and drawbacks of each option to enable you to make a well informed decision.