If you’re a high earner, there’s an oddity that could catch you out when you receive your payslip, because of the way that tax works in the UK. Notoriously known as the 60% tax trap, it all comes down to income tax rates and the personal allowance, if your earnings exceed £100,000.
So how does this tax trap affect your income, and most importantly, how can it be mitigated? In this article, we’ll explain how you can avoid this, with a little bit of expert financial planning.
Understanding the tax system
If you live in England, Wales or Northern Ireland, and are earning between £0 to £12,570 then you are within your Personal Allowance and do not have to pay any income tax. The income tax rate increases with your earnings:
- £12,570 to £50,270 – a basic income tax rate of 20%
- £50,271 to £150,000 – a higher rate of 40%
- Over £150,000 – an additional rate of 45%
You can see how things get complicated as you earn over £100,000, as you begin to pay a combination of basic rate and higher tax rate. Not only is there an increased income tax rate, but your personal allowance is also cut (£1 for every £2 of additional income). Reach an income of over £125,140 and your tax-free personal allowance is a disappointing zero.
Let’s break this down further. For every £100 of income between £100,000 and £125,140, £40 is taken for income tax, and your personal allowance is gradually cut by £1 for every £2 of income earned. In this example, this means that for every £100, £50 is lost. That £50 is then also taxed at 40%, equalling £20. You have therefore lost a total of £60. Therefore, the earnings within these thresholds have effectively been taxed at a rate of 60%. The more you earn over £100,000, the worst it gets.
As daunting as this tax-trap sounds, when you hit the six-figure mark for your earnings, there is a solution — pension contributions.
Using your pension to avoid the tax trap
Tax minimisation is one key area of a wealth management plan, and it’s the unlikely product of pensions that can help you to achieve this effectively.
This is because of the tax-relief incentive from the government. The rates of tax relief are the same as the income tax rate:
- Basic rate tax payer – 20% pension tax relief
- Higher rate tax payer – 40% pension tax relief
- Additional rate tax payer – 45% pension tax relief
The great thing about pension contributions, is that not only do you benefit from the higher tax relief – as an earner of over £100,000 – you can also reduce your annual income below the notorious 60% tax trap.
For example, if you are given a £1,000 pay-rise or bonus, instead of letting it be ravished by the tax trap, you could turn this into a pension contribution. This money will then receive the 40% pension tax relief, and your income is taken below the threshold. It may also be topped up further by your employer’s contributions.
Essentially, the money that you save for later on in life can work to help restore your lost personal allowance now.
Consider taking financial advice
As a high earner, the numbers surrounding income tax, personal allowance and pensions can get confusing. Therefore, it’s recommended to get professional financial advice when you reach that six-figure income, to ensure that your wealth is managed by the experts.
With a financial adviser, you can manage your wealth effectively as a high-earner, avoiding the dreaded tax-traps and their effects on your income.
Disclaimer: Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.