Secret tax raid as millions more people pay higher-rate tax by 2024

Fiscal drag means that 2.5 million more UK taxpayers could pay higher-rate income tax by 2024. Our personal finance editor Alice Guy examines why we’ve been paying ever more income tax over the past 20 years.

The inflation juggernaut is hurtling at full speed and smashing through our savings and budgeting plans. But for the government, inflation can be a good opportunity for a stealthy tax raid.

Fiscal drag is the ultimate stealth tax. It makes it harder to save and leaves less of our money free for investing and building wealth. We get a pay rise, but a big chunk of it is spent on tax and we have less money in our pockets.

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Fiscal drag works by freezing tax thresholds so that, as wages rise with inflation, tax thresholds stay the same. More and more of us end up paying higher rates of tax, and our take-home pay is eroded in real terms.

Here, we take a look at how fiscal drag is making us poorer and also explain ways to fight back and save on our tax bills.

Fiscal drag sucks more into the higher-rate tax bracket

Higher-rate taxpayers pay 40% income tax on all their earnings above the higher-rate tax threshold, currently £50,270.

But Rishi Sunak has decided to freeze the basic and higher-rate tax thresholds from 2022 to 2026. At a time of high inflation and increasing average wages, this will suck more and more people into the higher-rate tax bracket.

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In the year 2000, higher-rate tax of 40% was paid by the top 9%: a small minority of all taxpayers. But now around 13% of taxpayers pay 40% tax on their earnings and that figure is set to climb further as inflation drags more of us into the higher-rate tax bracket.

Pension experts and actuaries LCP have estimated that there will be 2.5 million more of us paying 40% tax by the tax year 2024 to 2025.

How much more income tax will you pay?

And even basic-rate taxpayers are affected, as the personal allowance of £12,570 is frozen until 2026.

Our calculations show that by 2026, a basic-rate taxpayer earning £20,000 will see their take-home pay reduced by £558 in real terms due to the personal allowance not keeping pace with inflation. That’s assuming their salary increases with inflation, but the personal allowance stays the same.

Higher-rate taxpayers will see an even bigger impact on their earnings. Someone earning £65,000 will have £2,608 less in their pocket in real terms by 2026, due to the frozen personal allowance and higher-rate tax threshold.

For very wealthy earners, the tax grab is even worse. Someone earning £250,000 will see their net earnings reduce by £5,734 due to fiscal drag.

Capital gains tax hike

And if you have an investment portfolio, you might also feel the affect of the frozen capital gains tax annual allowance.

If you sell shares or property, the amount you can sell tax free is frozen at £12,300 between 2021 and 2026. And selling a chunk of your share portfolio, or a second property, will cost you an extra £1,036 in real terms by 2026 as the annual allowance lags behind inflation.

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More of us paying back Child Benefit

And those of us with kids may also feel the pinch as more and more of us lose out to the higher income child benefit charge.

The tax charge affects earners on more than £50,000 and means that you’ll have to pay back some or all of your child benefit. An earner on £60,000 with two children has to pay back a total of £1,885 every year. That’s on top of £2,608 extra tax due to the higher-rate tax band being frozen.

The current child benefit rules and the £50,000 threshold was set by George Osborne in 2013 at a time when £50,000 was worth a lot more than today.

More owing inheritance tax

And Britain’s most-hated tax, inheritance tax, is also the subject of fiscal drag.

The inheritance tax threshold, currently £325,000 for a single person, has been frozen until 2026, making more estates eligible for this 40% tax.

Fight back with these tax tips

So, is there anything you can do to fight back against the affect of fiscal drag? Here are a few tips:

Make the most of pension tax relief

If you’re a higher-rate taxpayer then you can still get an extremely generous 40% tax relief on any pension contributions to a workplace or private pension scheme. It means that a £60 investment to a workplace pension will be topped up to £100. If you pay into a private pension, you may need to write to HMRC to claim your tax rebate as it won’t be paid automatically.

You’re allowed to contribute up to £40,000 per year into your pension if you’re not yet drawing an income. And even pensioners or those who are in the income drawdown phase are still allowed to contribute £4,000 per year to their pension.

• Pension tax relief: the secret weapon to combat inflation
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Protect your capital gains

You can also use a pension or stocks and shares ISA to protect your investment wealth from capital gains tax.

You can save up to £20,000 per year into a cash or stocks and share ISA, per person. The allowance can’t be backdated so you need to use it or lose it.

Shield your dividend income

Dividend income is currently taxed at a slightly lower rate than most income, at 8.75% for basic-rate taxpayers and 33.75% for higher-rate taxpayers.

But, just like capital gains tax, you can avoid this tax altogether by using a stocks and shares ISA or a pension to invest.

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Use your pension to avoid inheritance tax

And, if you’re lucky enough to have enough income and do not need to use your pension pot, you may be able to use it to avoid inheritance tax. That’s because investments held in a pension scheme can be passed on outside your estate and won’t usually attract inheritance tax.

If you need help with tax planning, then it’s a good idea to consult an independent financial adviser who will be able to assess your financial situation and give you tailored advice.