Earning £100,000 or more? Try these tricks to avoid a massive tax bill

More people than ever are earning six-figure salaries, but well-off workers face an eye-watering increase in their tax bill. Here’s how to limit the impact.

A £100,000 annual salary might be a very satisfying earnings milestone, but without any planning, the tax implications of a six-figure salary can easily take the shine off your pay rise.

That’s because you’re likely to be hit with a surprisingly large tax bill and start paying tax at an effective rate of 60%.

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Check the HMRC website and you’ll rightly see that the income tax rate for somebody earning £100,000 (remember, that includes your basic salary, bonuses and other earnings) is 40% and it only goes up to the additional rate of 45% once your earnings are north of £125,140. There certainly isn’t mention of a 60% tax rate.

How the 60% tax trap happens

The so-called 60% tax trap happens thanks to the gradual removal of the personal allowance, once your earnings exceed £100,000.

The personal allowance – which is currently £12,570– is the amount you earn each year before you start paying income tax. However, once you earn more than £100,000, that allowance starts to be removed at a rate of £1 for every £2 you earn over that threshold.

This has the effect of boosting the amount of income tax you pay by 20% on earnings between £100,000 and £125,140.

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Take the example of a £1,000 pay rise, that takes your income to £101,000 a year.

That £1,000 will be taxed at 40%, meaning you’ll pay £400 in income tax. But, the 2:1 rate of removal on the personal allowance will also mean you also lose £500 of tax-free income. So, that £500 will also be taxed at 40%, adding a further £200 tax to your bill.

This means the total income tax you pay on your £1,000 pay rise is £600, equating to a 60% income tax bill.

Can I avoid the 60% tax trap?

With a bit of planning, it is possible to avoid the 60% tax trap.

You can’t wriggle out of paying income tax, but you can reduce the amount of income you pay tax on. That might sound counter-intuitive, but done properly, it is possible to do so in a way that doesn’t hurt you financially. In fact, it can even boost your long-term financial security.

Pay more into your pension

The easiest way to side-step the 60% tax trap is to simply increase your pension contributions to reduce your taxable income.

This works because tax relief means you don’t need to pay income tax on any money you pay into your pension.  So, going back to that £1,000 – if you take it as salary, you’ll only take home £400 after 60% tax has been deducted. But, if you pay it into your pension, you’ll get its full value, without paying any tax on it.

Although you won’t be able to access that money until you are 55 (rising to 57 in 2028), you will get £600 more than you would if you had taken the money as salary. In addition to reaping the rewards of being invested for the long haul, this money will also be sheltered from further tax as it grows. You’ll also be able to take 25% of your pension as tax-free cash. 

Exactly how tax relief on your pension works depends on the scheme.

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If it’s a work scheme and it runs on a ‘net pay’ basis, it’s good news as you’ll get the correct rate of tax relief applied automatically and you won’t have to take any further action. This is simply because your contribution is paid before income tax is deducted.

However, if it’s a ‘relief at source’ scheme, it’s a bit more complicated. Under these arrangements your pension contributions are taken from your taxed income. Your pension provider will then claim basic rate tax relief (20%) on your behalf and pay it into your pension for you, but if you pay higher or additional rate tax you’ll have to claim the outstanding relief you’re entitled to through your self-assessment tax return.

Personal pensions you’ve set up yourself, such as a SIPP, will work on a relief at source basis, as will some workplace pensions. If you aren’t sure how your work scheme operates, check with HR.

Talk to your employer about non-cash benefits

Another way to reduce your taxable income is to talk to your employer about trading a pay rise (or bonus) for non-cash benefits.

This can be set up using salary sacrifice, where you forgo taxable salary to pay for benefits including childcare, private medical insurance and company cars (with additional tax incentives if you go for an electric car).

In addition to reducing your income tax bill, salary sacrifice will also reduce the amount of National Insurance you and your employer pay, meaning there’s a good chance they’ll be happy to set it up for you if they’re not offering it already.

Consider other tax-efficient investments

Pensions aren’t the only investments to offer tax breaks. There’s also a range of investments, designed to help start-ups, that offer generous incentives to investors with an above average tolerance for risk.

Venture Capital Trusts, or VCTs, for example, offer 30% tax relief on investments up to £200,000, so long as you keep them for five years.

However, before investing in start-ups, it’s important not to get blindsided by the tax benefits. Start-ups and smaller companies have a higher risk of failure and are only suited to wealthier investors with an aggressive attitude to risk.

Give money to charity

You might also want to consider giving money to charity, so your money goes to a good cause instead of the taxman. This is because Gift Aid means the charity can claim basic rate tax-relief, boosting the value of your contribution by 25%. Higher and additional tax rate taxpayers can claim outstanding relief back via self-assessment.

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Register for self-assessment

As soon as your income exceeds £100,000 before tax, it also becomes a legal requirement to file a self-assessment tax return.

You’ll need to file your tax return by 31 January and fines may be payable if you miss the deadline, so it’s a good idea to register for self-assessment as soon as you can to give yourself as much time as possible to complete it.

Completing a tax return will always be a chore, but it’s an important part of tax planning and, particularly with pensions, is an essential part of making sure you are getting the tax relief you’re entitled to.

And a final warning for higher earners

Once your earnings exceed £125,140, the tax headache doesn’t get any better. At this point you won’t have a personal allowance and will pay tax on 100% of your earnings. You’ll also start having to pay the additional rate of tax, which is currently 45%. This follows the chancellor’s Autumn Budget tax squeeze which saw him reduce the threshold for the top rate of tax from £150,000 to £125,140.

According to government figures this will affect 792,000 taxpayers, 232,000 of whom will start paying the additional rate for the first time. It’s expected to cost those earning between £125,140 and £150,000 around £621 a year, while those earning over £150,000 will typically have to stump up an extra £1,256 in tax this year.

However, by taking steps to reduce your taxable income it may still be able to avoid or at least reduce the impact of the tax hike.