Earn over £100k? You may fall into the 60% tax trap

In November 2022 the Chancellor Jeremy Hunt delivered his first Autumn Statement, which had many focusing on the news of a reduction in the amount at which you pay additional rate tax. From the 6th April 2023 the additional rate tax threshold will be lowered from £150,000 to £125,140, meaning tens of thousands more people will be pulled into the UK's highest tax rate band of 45%. 

 In addition to this, it was also announced that the current freeze on income tax personal allowances and the higher rate threshold, originally announced in 2021 and meant to last between 2022 and 2026, would now be extend for further two years to 2028.  This "stealth tax" will see even more Britons paying more tax and moving into higher tax band thresholds over the coming years, particularly given soaring inflation. 

According to the Telegraph, the changes mean that by 2028 Britain's complicated tax system could capture at least 700,000 more taxpayers into the 60% tax trap, which affects workers earning between £100,000 and £125,000. Are you one of them?

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What is the 60% tax trap?

The current UK income tax bands are charged at 0%, 20%, 40% and 45% (this differs slightly if you live in Scotland where it is 0%, 19%, 20%, 21%, 41% and 46%). This implies that the highest marginal rate of income tax in the UK that one could pay is 45%. However, a quirk in the tax system results in an effective rate of 60% (61% in Scotland) for a portion of some taxpayers' income.

Once your earnings exceed £100,000, you begin to lose your Personal Allowance of £12,570 (frozen until 2028). For every £2 you earn over £100,000 each year; you lose £1 worth of your £12,570 tax-free personal allowance. Your tax rate only returns to the normal higher rate tax band of 40% after the entirety of your personal allowance for that year has been deducted, which is those earning just over £125,000.

For example, someone earning £100,000 who receives a bonus of £10,000 will only receive £4,000 of his bonus. This works out as follows: 

He immediately loses £4,000 to the standard 40% higher rate tax, leaving him £6,000. As he loses £1 for every £2 earned over £100,000, his £10,000 bonus translates to £5,000 deducted from his original tax-free personal allowance. This deduction of £5,000 is then retroactively taxed at his current standard rate of 40%, meaning he pays another £2,000. 

After paying the original tax of £4,000 and then the subsequent tax of £2,000, he is left with only £4,000 of his original £10,000 bonus, meaning he has effectively experienced a 60% tax rate.

How to beat the 60% tax trap

Pension contributions

One of the quickest and most straightforward strategies to avoid the 60% tax trap is to consider making a pension contribution that reduces your earnings to under £100,000.

Using the above example, your two most common options are:

1) Opt for the bonus payment of £10,000 to be paid directly into your pension via salary sacrifice.

Salary sacrifice is when you give up a portion of your salary in exchange for another comparable benefit, in this instance an employer pension contribution. This option enables you to reclaim your personal allowance, receive tax relief and save on national insurance contributions on the amount you pay into your pension.

2) Make a personal pension contribution via your savings.

You would need to make a payment of £8,000 into your pension, which HMRC would automatically top up by £2,000 due to tax relief on pension contributions, resulting in a gross contribution into your pension of £10,000. This has the effect of reducing your net adjusted income below the £100,000 threshold, which means that you have beaten the 60% tax trap. So, not only have you gained £2,000 in tax relief straight into your pension, but you’ve also saved the same again by reclaiming your personal allowance. Furthermore, higher-rate tax relief can then be reclaimed on your tax return to bring the total net cost of the pension contribution to just £4,000.

Both these options allow you to regain your personal allowance, pay less tax, and significantly contribute to your future. 

You can typically pay a maximum of £40,000 into your pension each year and still receive tax relief on your contributions (subject to relevant UK earnings). 

Although a pension can be a great tax-efficient way to save for your retirement, you should always determine whether making large pension contributions suits your personal circumstances and financial goals.

Other ways to beat to 60% tax trap

There are other ways to beat the tax trap. Some different strategies again utilise the benefit of salary sacrifice, and this time the comparable benefit can be: 

• Cycle to work schemes, 
• Childcare vouchers, 
• Low-emission cars.

A further option could be to make a charitable donation under Gift Aid. 

Need help? Speak with a Financial Planner

As stated at the outset, the UK tax system is complicated and can be confusing and time-consuming to navigate. With the frequent changes to the tax system, you may be wondering where to start. 

By engaging with a Financial Planner, it's possible to understand the most appropriate strategy for your needs and how that strategy impacts you, ultimately giving you peace of mind that you are making the best decisions.

Our tax planning services include certain products, allowances and guidelines to ensure your money is working its hardest and to ensure the tax you pay is ultimately a fair, yet minimal, amount. Why not get in touch and speak to one of our expert advisers today and see how we can help you.

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Please note: A pension is a long term investment. The fund value may fluctuate and can go down. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation. The FCA does not regulate Tax advice or tax planning.