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Have you fallen victim to the 62% ‘tax trap’?

In November 2022, the UK’s Chancellor of the Exchequer Jeremy Hunt announced plans to reduce the threshold above which people would start to pay additional rate tax of 45%. From the 6th of April 2023, more Britons were dragged into the additional rate tax bracket as the 45% income tax levy, which previously applied to any income over £150,000, increased to apply to all earnings over £125,140.

In addition to this, Jeremy Hunt also announced that the Government was extending the freeze on the personal allowance, along with income tax thresholds for basic and higher rate, for a further two years on what was previously announced. 

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To better explain, the freezing of the income tax thresholds, which was originally announced in 2021, was meant to remain in place from 2022 to 2026. However, this was extended a further two years to 2028. Coined a modern day ‘stealth tax’, these tax freezes and the additional rate threshold reduction have pulled more and more Britons into higher rate tax bands. However, the additional rate of tax at 45% is not the highest rate you could be paying, in fact many more are now being dragged into the 62% tax trap. Are you one of them? 

What is the 62% tax trap?

You may have been thinking that the highest rate of income tax payable was 45%, at which point the rate of National Insurance is 2%, giving an effective tax rate of 47%.

But did you know you could be subject to an effective combined rate of income tax and national insurance of 62% if you earn over £100,000?

The 62% tax trap refers to the income band falling between £100,000 and £125,140 on which the employed or self-employed will effectively experience an income tax rate of 60% alongside national insurance contributions of 2%.

This is because for every £2 you earn over £100,000 per annum, you lose £1 worth of your £12,570 tax-free personal allowance.
Your tax rate only reduces to the additional rate of 45% after the entirety of your personal allowance for that year has been eroded, i.e. on income above £125,140.

Let’s bring this to life with an example of how the 62% tax trap works...

If we assume an individual who has earnings of £100,000 for the year, and they receive a bonus of £20,000.

From this bonus, £8,000 is immediately lost to standard 40% higher rate tax.

The double jeopardy here is the reduction in the personal allowance, which is reduced from the full entitlement of £12,570 to £2,570. This reduction of £10,000 means there is an additional £10,000 of income that sits within the higher rate tax bracket and is subject to 40% income tax. This is equivalent to a further £4,000 of income tax payable.

And then finally, there is the national insurance contribution payable on the bonus, which is at 2% above the higher rate tax threshold of £50,270, equating to £400 in this example.

The result is an effective tax rate of 62% with the individual taking home £7,600 of their £20,000 bonus!

How can I mitigate the 62% tax trap?

Now you might be thinking, how can I avoid falling into the 62% tax trap? One of the main levers you can pull to help reduce your tax liability, and help you to avoid this trap, is increasing your pension contributions, as this reduces your ‘adjusted net income’.

Pension Contributions

By making pension contributions you can reduce your effective income and keep your ‘adjusted net income’ below £100,000, allowing you to preserve your personal allowance of £12,570. 

You may have the option to make additional pension contributions by opting for part / all of any salary and/or bonuses to be paid directly into your pension via salary sacrifice. By opting for this approach, you receive your tax relief 'straight away' as you, in practice, will reduce your taxable earnings before any tax is paid. Via this method, a national insurance reduction also applies, giving a potential tax relief rate of up to 62% on pension contributions.

Alternatively, you can increase your personal or employee contributions which are made from post-tax income, which effectively receive 60% tax relief (the national insurance ‘cost’ is already suffered and cannot be reclaimed). Any pension contributions you make will receive tax relief of 20% from HMRC, which is added to the pension plan to which the contribution is made. This means if you were earning £120,000 and made a personal contribution of £16,000, HMRC would top this up by £4,000 to provide basic rate tax relief, resulting in an overall contribution of £20,000. This reduces your earnings by £20,000 bringing ‘adjusted net income’ down to £100,000 and avoiding the ‘tax trap’ by regaining the £10,000 of lost personal allowance to give a full personal allowance of £12,570.

Furthermore, as a higher rate tax payer you can also reclaim a further 20% tax relief via completing a self-assessment tax return or contacting HMRC directly. This means a ‘gross’ contribution of £20,000 will effectively only ‘cost’ you £12,000, before we factor in the Personal Allowance reduction being reversed, which provides a further tax saving of £4,000. This gives a ‘cost’ of £8,000 for a personal contribution of £20,000 in total, a massive £12,000 tax saving. 

Depending on your income for the tax year and the level of any employer contributions being made, you may be able to pay up to £60,000 into your pension and still receive tax relief on your contributions. You can sometimes make additional contributions into your pension if you have unused annual allowance from previous tax years 

Charitable donations

There are other options to reduce your income to avoid falling into this tax trap. Charitable donations, similar to pension contributions, decrease your ‘adjusted net income’ and can allow you to reclaim some / all of your personal allowance.

Learn more about how you can avoid this trap

Controlling your income to reduce your tax bill can be complex and time-consuming, but by engaging the help of a financial adviser we can advise and assist you on the best approach to suit your own personal situation and circumstances.

Please do get in touch if you have any concerns that you might be affected by this tax trap, or if you had any queries on general pension and financial planning as a whole. We’re offering anyone with £100,000 or more in pensions, investments or savings a free cash flow review worth £500

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions. 

The Financial Conduct Authority (FCA) does not regulate cash flow planning, estate planning or tax advice.