No doubt you’ve read about the high tax burden in the UK. It plays out in the media quite a lot. Politically it seems there is no chance of tax cuts in the near future. Liz Truss attempted to cut taxes in 2022, but that ended in spectacular failure. We don’t know how tax rates and allowances may change in the future, so we can only plan based on the rules as they stand.

Even if you are keenly aware of the UK’s high tax burden you may not know about the 60% tax trap. It isn’t a widely publicised tax rate, but it is very real and affects at least 3% of the population.¹

Tax rates and the 60% tax trap

The current income tax rates on earnings if you live in England, Wales and Northern Ireland are in the table below.

Earnings                            Rate

£0 to £12,570                    Personal allowance: no income tax payable

£12,501 to £50,270           Basic rate: 20%

£50,271 to £125,140          Higher rate: 40%

Over £125,141                     Additional rate: 45%

However, when your income exceeds £100,000 you lose your personal allowance by £1 for each £2 of additional income. For example, if you earned £100,000 per year and received a £10,000 bonus you would also lose £5,000 of your personal allowance. This means that the £10,000 bonus will attract 40% higher rate tax, and the lost £5,000 from your personal allowance would be taxed at 40% too. Your effective tax rate for this £10,000 bonus is now 60%, and you only get £4,000 out of the original £10,000.

How to avoid the trap
You can avoid the tax trap through pension contributions, as pension contributions may allow you to recoup some of your lost personal allowance. Pension contributions could be made by salary sacrifice via your employer or can be made personally. A pension contribution should be carefully considered though.

A pension is a long-term investment and cannot be accessed to 55, increasing to 57 from 2028. There is also a limit to annual pension contributions, the lesser of £60,000, or 100% relevant UK earnings. Further, you may be affected by the tapered annual allowance if your earnings exceed £260,000 per year. Tax efficiency is very important, but any contribution should also suit your goals and circumstances. Your capital is at risk. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested.

Free childcare and the tax trap
Being aware of this tax trap is even more important if you have children eligible for free childcare. If you are planning to make use of free childcare and you or your partner expect an ‘adjusted net income’ over £100,000 then you will lose the free childcare hours. If you have multiple children then the issue is compounded, and your available income is seriously reduced. Take the example of a person with two children eligible for free childcare who earns just shy of £100,000. If they received a pay rise or bonus they lose those very valuable free-childcare hours, which could be worth up to £10,000 per child.

Therefore, factoring in the cost of childcare and the 60% tax trap, parents of young children may be significantly worse off. After tax-income falls at £100,000 and wouldn’t recover until their earnings reach £145,000.

Business Owner
The same logic applies if you are a business owner, and your main source of income is dividends. While the 60% tax trap doesn’t apply as dividend tax rates are lower, you do still lose your personal allowance if your income exceeds £100,000. As a business owner you generally have more control over your cash flow, so if you do not need the money in your pocket then you could consider pension funding as a means of wealth extraction.

Summary
In summary, while increasing your earnings is generally a good thing, if your income is near the £100,000 threshold you should consider taking advice, so you don’t fall into the tax trap.

*Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.

*The Financial Conduct Authority does not regulate tax planning.

¹ Income percentiles