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Are you caught in a 60% income tax trap?

You could be paying more tax than you think.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Most people think the highest rate of income tax in the UK is 45%.

But there are actually two situations where you could be paying much more, without even realising it.

Inconsistencies in the UK tax system mean that some people pay up to 60% effective tax rates on certain parts of their income.

This is more common than you might think – and those affected aren’t the super-rich either. An estimated 625,000 people could be paying these higher rates of income tax.

Below we’ll explain what to look out for. Thankfully, there’s an easy way to avoid these traps while saving for retirement at the same time.

The child benefit trap

Families where one partner earns more than £50,000 a year face a tax charge of 1% of their child benefit for every £100 earned between £50,000 and £60,000.

This could affect 375,000 parents.

If you have two children and the higher earner earns £50,000 a year, you’ll receive almost £1,790 per year in child benefit. But if you earn £1,000 extra, this costs you £179 in child benefit, as well as £400 in income tax.

That’s £579 in total – an effective tax rate of 57.9%.

What could you do about it?

Contributing to a pension reduces your income for tax purposes.

In the above example, making a £1,000 pension contribution can mean you don’t pay the £179 tax charge on your child benefit and you receive up to 40% tax relief on your contribution. Here’s how:

  • You make an £800 payment
  • The government adds £200
  • As a 40% taxpayer, you can claim back up to an extra £200 through your tax return
  • This reduces the effective cost to as little as £600
  • Your income is treated as if it’s been reduced by £1,000 for the purpose of the child benefit tax charge, so you save £179

Adding £1,000 to your pension effectively only costs you £421, because you avoid paying a 57.9% effective tax rate on that part of your income.

The personal allowance trap

This one affects an estimated 250,000 people.

If you earn under £100,000 per year, you’ll usually benefit from an annual tax-free personal allowance of £11,850. This means the first £11,850 of your income isn’t taxed.

But once your income goes above £100,000, the tax-free personal allowance tapers away at a rate of £1 for every extra £2 you earn. This means your personal allowance is zero if you earn £123,700 or more.

If you’re currently earning £100,000 and you get a £1,000 pay rise, not only will this cost you £400 in tax on the £1,000, but you’ll lose £500 of your personal allowance. This means an extra £500 is now taxed at 40%, costing you another £200 in tax.

So earning that extra £1,000 costs you £600 in tax. That’s a 60% effective tax rate.

What could you do about it?

Again, pension contributions can help.

In the above example, making a £1,000 pension contribution can mean your personal allowance is reinstated and you also receive up to 40% tax relief on your contribution. Here’s how:

  • You make an £800 payment
  • The government adds £200
  • As a 40% taxpayer, you can claim back up to a further £200 through your tax return
  • This reduces the effective cost to as little as £600
  • Reducing your income below the £100,000 limit means your personal allowance is reinstated, saving you a further £200 in tax.

Adding £1,000 to your pension effectively costs you just £400, because you avoid the 60% tax trap on that part of your earnings.

What to be aware of...

The exact benefits described here depend on individual circumstances. For example, Scottish taxpayers pay different rates of tax to the rest of the UK. To receive tax relief, you must be under 75 and the value of your contributions should not exceed your earnings. You must pay sufficient tax at the higher rate to claim the full higher-rate tax relief via your tax return.

You’ll normally only be able to take money from your pension from 55 (57 from 2028), usually up to 25% tax free and the rest taxed as income. Tax rules can change.

A simple way to pay less tax – but consider acting before Monday 29 October

Putting money in your pension could considerably reduce the tax you pay.

As shown above, this could be particularly beneficial if you find yourself caught by any of the traps in the tax system.

Your pension contribution could save you paying an effective tax rate of up to 60%.

With the Budget approaching on Monday 29 October, rumours are circulating that the amount which can be contributed could be restricted.

It could be a wise move to bring forward any planned pension contributions.

In the past, some changes have taken immediate effect. If the same happens next week, anyone who acted before the announcement should benefit from the current tax-relief system.

Most UK workers can contribute as much as they earn, and get tax relief. Contributions are also limited by the annual allowance which for most people is £40,000. This includes any pension contributions from you, your employer, and any benefits accrued in a final salary scheme.

Those with adjusted income of over £150,000 may have their annual allowance reduced to as little as £10,000.

How much could you pay in?

You could also carry forward any unused allowance from the last three tax years, which could mean you could make an investment of up to £160,000. If you’re a 45% taxpayer, this could mean up to £72,000 in tax relief.

Invest up to £160,000 with 'carry forward'

How to make a pension contribution

It’s easy to start a SIPP (self-invested personal pension) with a contribution before the Budget announcement on Monday 29 October.

Find out more about the HL SIPP

If you’re not ready to choose your investments right now, don’t let that stop you from sheltering your money before the Budget. You can make your pension contribution today and simply hold the cash in your SIPP while you decide where to invest it.

Remember all investments can fall as well as rise in value, so you could get back less than you invest.

This article and our guides are not personal advice. If you are unsure of the suitability of any investment, please seek advice. For more information about how pension tax relief works, read our free guide.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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