The root cause of the 60% tax trap is the reduction in the personal allowance, the amount of income that is exempt from tax.
If you earn between £100,000 and £125,140 a year, you are a victim of an anomaly in the tax system that causes you to lose more than half of your income to tax: the 60% tax trap. This peculiar irregularity in the tax system can result in an effective tax rate that exceeds the official top rate of 45%, creating financial challenges for individuals in this taxable income bracket. In this article, we look at this issue and offer you some possible options to avoid falling into the trap.
Understanding the 60% tax trap
The root cause of the 60% tax trap is the reduction in the personal allowance, the amount of income that is exempt from tax. Currently set at £12,570, this allowance gradually decreases by £1 for every additional £2 earned above £100,000. As a result, for every £100 earned between £100,000 and £125,140, only £40 ends up in your pocket - £40 in income tax and a further £20 lost to the reduction in the personal allowance.
Brewin Dolphin, one of the UK's largest wealth management firms, explains it even better: "Suppose you earn £110,000 - or £10,000 above the threshold. Not only would you pay £4,000 in higher rate tax on that £10,000, but you'd also lose £5,000 of your personal allowance. And with £5,000 of your personal allowance gone, that part of your income will now also be taxed at 40%, costing you a further £2,000. In other words, you'd only be able to keep £4,000 of that £10,000, which equates to a 60% tax rate.
If you live in Scotland, the situation is even worse for higher-rate individuals, with an effective tax rate of 63%. This is because income in the higher rate band is taxed at 42% in Scotland. Using the same example, you'd pay £4,200 tax on the £10,000 of income above the threshold, plus £2,100 tax on your lost personal allowance. Of the £10,000, you'd only take home £3,700, giving you an effective tax rate of 63%.
Mitigating the impact with pension contributions
While the 60% tax trap may seem like a concern only for the financially fortunate, there are effective strategies to mitigate its impact. One such strategy is the use of pension contributions, a move that not only reduces your income tax liability but also improves your financial future.
Pension contributions play a dual role in combating the 60% tax trap. Firstly, they help to reclaim your personal allowance and secondly, they provide tax relief on the amount you contribute. For example, if you earn £100,000 and receive a bonus of £1,000, contributing this bonus to your pension not only gives you a 40% higher rate tax relief but also reduces your annual income, keeping it below the £100,000 threshold and preventing you from entering the 60% tax trap.
Demystifying Pensions: A powerful tax planning tool
Contrary to the misconception that pensions are inflexible or boring, they prove to be a highly effective tax planning tool. The government incentivises pension saving by offering generous tax relief rates that mirror those paid on earned income. Basic rate taxpayers receive 20%, higher rate residents receive 40% and additional rate taxpayers receive an impressive 45% tax relief on their pension contributions.
Saltus Financial Planners reminds us to keep in mind that there is a limit of £60,000 for annual pension contributions. Additionally, individuals with a taxable income exceeding £260,000 will experience a reduction in their annual pension allowance. For every £2 earned above £260,000, the personal allowance decreases by £1. To avoid any surprise tax bills due to unintentional breaches of the cap, seeking the assistance of a financial adviser is highly recommended.
Having a knowledgeable adviser by your side is crucial when it comes to navigating the ever-changing landscape of tax and pension rules. With regulations being subject to sudden modifications, having someone who can stay informed and keep you updated is invaluable. An experienced adviser can identify any potential impacts on your personal situation and guide you on how to respond effectively. By having an expert on hand, you can confidently stay ahead of any changes that may affect your tax and pension planning.
Navigating Complexity with Professional Guidance
It is important to recognise the complexity of pension planning. While pensions offer significant benefits, determining whether or not significant contributions are appropriate for your personal circumstances requires careful consideration. Seeking professional financial advice is essential in such scenarios, as financial advisors can assess your situation and tailor a strategy to meet your specific needs.
Let us not succumb to the challenges of the 60% tax trap. Instead, let us empower ourselves with the tools and strategies available, such as pension contributions, to ensure that we are not burdened with unnecessary tax payments. Remember, it is not just about the money we earn, but also the money we keep for a secure financial future. Make your pension work for you.
Compare Wealth Managers offers a free service to help you find a wealth manager. Simply click the orange "start comparing" button to get started.
