Do you fall in to the 60% tax trap?

Most people believe that there are three rates of income tax in the UK, 20%, 40% and 45%. However, there are situations where you could be paying above the top rate of 45% tax, with higher earners paying an effective rate of 60% tax on certain parts of their income.

How?

If you earn £100,000 or over your tax-free personal allowance (currently £12,500) is “tapered” away at a rate of £1 for every £2 above the £100,000 limit. Meaning, once you earn £125,000 or over, you fall in to the “tax trap” and do not benefit from a tax-free personal allowance each year.

To put the tax trap into practice, if you are earning £100,000 and you get a £1,000 pay rise, it will cost you £400 in tax but, you will also lose £500 of your personal allowance, meaning an extra £500 of your salary if now taxed at 40%, costing you a further £200. Therefore, of your £1,000 pay rise you will only receive £400 due to the 60% tax trap.

What can you do about it?

By making regular or one-off pension contributions you could recover some, or all of your personal allowance and in effect you will receive up to 60% tax relief on your contribution.

Here is an example, based on starting income between £101,000 and £125,000:

1. You make a pension contribution of £800.
2. The government adds £200, making a “gross” contribution of £1,000.
3. As you are a 40% tax payer you can claim back a further £200 via your tax return.
4. Your income is effectively ‘reduced’ by £1,000 meaning you get back £500 of your tax-free personal allowance, saving you a further £200 in tax.
5. Therefore adding £1,000 to your pension only costs you £400 having saved you 60% in tax.

The benefit would be maximised if you earn £125,000 and are able to make a gross contribution of £25,000 to your pension (as this would only cost you £10,000) but even if you earn £130,000 and can add £10,000 to a pension, half of this would in effect get 60% relief and the balance still gets 40% for example.

Remember, this needs to fit with your wider plans and not just the tax savings as if you are making pension contributions, you usually cannot access the funds until you are aged 55 or above.

What are the limits?

Every year most people can contribute the higher of £3,600 or 100% of earnings up to a maximum of £40,000. Some will be able to contribute more (by using the ability to “carry forward” unused allowances from the previous 3 years) and some will be limited by the tapered annual allowance (only potentially an issue for those earning over £210,000).

How can I save tax?

Should you wish to find out more about tax savings and how pensions could be used, then please get in touch.

Lee Smythe MSc