Earning over 100k?

How high earners can steer clear of the 60% tax trap

It’s time to shine the spotlight on a wrinkle in the tax code that catches out a lot of unsuspecting people every year. We call it the 60% tax trap.

What do we mean? Well, for those whose earnings go beyond £100,000 in any tax year, some of their income will effectively be taxed at an eye-watering 60%. This should be a particular focus towards the end of the tax year, as individuals often receive bonuses taking them over the £100k threshold at year end. They can be in for a fairly uncomfortable read when they receive their payslip.

Understanding income tax rates

So how does the tax trap catch people out? First of all, let’s take a look at the current income tax rates and thresholds for earnings if you live in England, Wales or Northern Ireland.[1]

Fortunately, there’s one very straightforward and tax-efficient way to steer clear of the tax trap: make pension contributions. Done effectively, this can help you reclaim your personal tax allowance and also receive tax relief on the amount you pay in to your pension.[3] In fact, it could turn a tricky – and expensive – problem into a highly tax-efficient solution.

Aren’t pensions a bit too inflexible?

It’s somewhat ironic that pensions have a reputation as such a traditional and conventional – dare we say it – even boring product. It also doesn’t help that investing in a pension is often unfairly presented as having to make a painful choice between spending the money now, or putting it away for retirement.

In reality, pensions can be far more flexible than most people give them credit for. The key is that the government offers really quite generous incentives to encourage people to save for their retirement. Think of it as a government bonus.

The tax relief from the government acts as a ‘top-up’ on the amount you contribute to your pension, and the rates of tax relief are the same as the rates paid on income earned. In other words, basic rate tax-payers receive 20% tax relief on their pension contributions, higher rate tax-payers receive 40% and additional rate taxpayers are in for huge 45% relief.

HMRC will not consider the £25,140 as part of your taxable income, consequently adjusting it back down to £100,000. So, not only have you gained £5,028 in tax relief straight into your pension, you’ve also saved the same again in higher-rate tax by reclaiming your personal allowance. Further higher-rate tax relief on your pension contribution can then also be reclaimed on your tax return to bring your total benefit up to £15,084 just by making pension contributions.[4]  In addition, if your employer offers salary sacrifice as part of your company pension scheme, your contribution will be paid in gross of all income tax.  It could also be gross of national insurance as well if your employer passes on the money they save.

*(40% of the taxable income £25,140 = £10,056) + (40% of the personal allowance £12,570 = £5,028)

Using your pension to take control of your taxes

If all of these numbers are starting to make your head spin, don’t worry. Pension planning can be complicated, so you should determine whether making large pension contributions suits your personal circumstances. A financial adviser can provide an assessment of your financial situation and determine a strategy designed specifically for your needs.

It’s also worth remembering that annual pension contributions are capped at £60,000.[5] Anyone with a taxable income of more than £260,000 will also see the annual allowance for their pension tapered – for every £2 of income earned over £260,000, their annual allowance is reduced by £1. A financial adviser can help you to avoid any unexpected tax bills that may result from accidental breaches of the cap.

More importantly, tax and pension rules can change at short notice, so it’s well worth having an adviser on hand who can keep on top of any changes. They can highlight anything that could affect you, and help you to respond accordingly.

This type of pension planning strategy can be of great benefit to high earners who don’t want to be unfairly penalised by the idiosyncrasies of the UK tax system, and recognise the value of paying into their pension while they can. Using this income to make pension contributions is both an instant solution to a difficult problem and also a way to significantly increase your retirement pot. It can though, be a struggle to manage if you have high income levels, significant investments of hundreds of thousands and multiple tax vehicles. In this scenario it’s probably best to take advice.