The tax trap affecting 500,000 workers and how to beat it

You may have noticed a handful of articles and social media videos emerged earlier this year which claimed earning somewhere between £100,000 and £125,000 puts you in the “worst” salary bracket in the UK.

Now, you don’t need me to point out that this is a gross exaggeration. No one of sound mind would assert that someone in the top 5% of earners, raking in three times the average UK wage, is the hardest done by financially.

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But despite the clickbaity headlines, these pieces lay bare a couple of snares in the UK tax system that affect those whose earnings trip into six figures.

The financial impact here can be considerable. Not only is there a punitive 60% income tax trap lying in wait, but some families could end up thousands of pounds worse off than if one parent earned a few quid less due to lost free childcare.

Due to a combination of rising incomes and frozen tax allowances - a stealthy tactic known as “fiscal drag” - more and more workers are getting caught in this net. The number of taxpayers affected by the 60% tax trap has ticked up almost a quarter (23%) in the past 12 months alone, jumping from 436,000 to 537,000.

Given Labour has pledged to maintain tax thresholds at their current level until 2028, more workers and families will be affected as time goes on.

So, is there anything you can do to either swerve or mitigate the effects? 

Let’s delve into how UK tax and childcare systems impact those with salaries or self-employed profits north of £100,000 and explore how pensions can help you keep more of your wealth.

What happens to tax once pay exceeds £100,000?

On anything you earn between £50,271 and £125,140, you pay income tax at 40%.

However, your personal income tax allowance – the amount you can earn every year tax free - reduces by £1 for every £2 once earnings exceed £100,000. The result is that, as the allowance is currently £12,570, it disappears once salary or self-employed profits hit £125,140.

The loss of your personal allowance means you pay tax on all your income, bringing the total equivalent tax rate on earnings between £100K and £125,140 to an eye-watering 60%. In other words, for every pound you earn, 60p is lost to income tax. What’s more, you pay 2p national insurance (NI) too, so you actually end up with just 38p.

Once income surpasses £125,140, the equivalent tax rate slows but it doesn't hit the breaks, as that’s when the 45p tax threshold kicks in. Again, you will pay 2% NI, so for every pound you earn on this portion of your income, 47p goes to HMRC.

Effect of 60% tax on salary

Source: gov.uk

What happens to free childcare once income hits £100K?

Every parent in the UK gets 15 hours of free childcare for three and four-year-olds regardless of their income. However, once earnings exceed £100,000, eligibility for 30 hours of free childcare ceases.

And unlike the 60% tax trap, a cliff edge is imposed rather than a tapered reduction as income rises. So, simply earning an extra £1 could result in 15 hours of lost childcare, which could be worth up to £3,000 a year.

What’s more, you would no longer qualify for tax-free childcare; a government initiative that provides up to £2,000 a year per child, or £4,000 for disabled children, under 11.

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It may come as no surprise to learn that the regime has come under fierce criticism. The UK income tax system is described as progressive, which means that higher rates are imposed on those with the highest incomes. To avoid unfairness, any uptick in personal income is taxed marginally. To put it another way, higher tax rates only impact your next pound of earnings, rather than the whole lot.

The UK childcare system runs contrary to this. As noted above, a modest pay rise could result in parents being financially worse off, and risks deterring workers from increasing their salaries.

What’s more, eligibility is based on one person’s income rather than the household’s. This means two parents earning £99,000 each would keep free childcare, while a family where one earns £100,000 and the other nothing, may lose it.

The same criticisms are directed towards the child benefit system, where eligibility is also determined by individual rather than household income.

The power of pensions

It stands to reason that people won’t want to take a lower-paying job or reject a salary rise just to be able to claim free childcare or swerve punishing tax charges.

And the truth is, you don’t have to. A useful tactic to consider is to make or increase pension contributions, provided you are prepared to forgo access to the money until age 55 (rising to 57 in 2028).

So, how does this handy trick work?

Let’s say you are a sole trader, married with one child (aged three) and will have profits of £125,000 in the current tax year, and no other taxable income. Unless you take action, you could forgo most of your £12,570 personal income tax allowance and thousands in free childcare.

However, if you made a one-off contribution of £20,000 to an interactive investor self-invested personal pension (SIPP) you will get upfront tax relief in the form of a 25% government boost, beefing up your contribution to £25,000.

As the total value of pension payments reduce what’s called your “adjusted net income”, your taxable income for the year will fall to £100,000 (£125,000 minus £25,000).

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The benefits of this approach are potentially four-fold. First, you get 40% tax relief on what you pay in, meaning £25,000 contribution effectively only costs you £15,000 (just make sure you or your accountant sticks it on your tax return).

Second, you get to keep all your personal income tax allowance, helping to fully swerve the 60% tax trap and, importantly, putting an extra £5,000 in your pocket. Third, your pension savings get a shot in the arm, shunting you closer to a comfortable lifestyle.

And fourth, you may get to keep your 30 hours of free childcare, potentially beefing up your family’s coffers by thousands of pounds.

If you are employed, there could even be a fifth benefit. Should your employer allow you to do so, you could trade a portion of your salary for a pension payment – something known as “salary sacrifice”. This will enable you to avoid 2% NI too, equating to an extra £500 saving.

Many employers are more than open to this approach, as paying you a lower notional salary means they’ll pay less NI, too.

When it comes to your personal tax bill, to get upfront relief on pension contributions, you must stay within the annual pension limits. The good news is these are generous. Most workers can pay the lower of £60,000 or 100% of earnings into a pension every year and receive tax relief at their marginal rate.