How to steer clear of the 60% tax trap as a high earner
If you’re earning in excess of £100,000, then you could face some significant financial challenges. One of which is the notorious 60% tax trap.
But what does this disheartening figure mean? How are you caught out by the tax trap? And most importantly, how can you use your pension to get your money back?
Read on as we reveal the experts’ approach to avoiding the 60% tax trap.
Income tax rates and personal allowance
First of all, you’ll need to understand the income tax rates and thresholds for earnings in England, Wales and Northern Ireland. These are the rates and bands for the tax year 2021/22:
- Taxable income of £0 to £12,570 — tax rate is 0%
- Taxable income of £12,571 to £50,270 — basic tax rate is 20%
- Taxable income of £50,271 to £150,000 — higher tax rate is 40%
- Taxable income of over £150,000 — additional tax rate is 45%
The standard Personal Allowance is £12,570, at the time of writing. This is the amount of income you do not have to pay tax on. However, when you exceed an income of £100,000 your Personal Allowance gets smaller, as it is cut by £1 for every £2 of income earned over the six-figure threshold.
This means you lose your tax-free Personal Allowance completely if your income reaches £125,140, and you start paying the higher tax on your income much sooner than you may have expected.
How does the tax trap catch people out?
At the higher end of the scale, those earning in excess of £100,000 will pay a combination of basic rate and higher rate tax. But there’s also a catch that could see their income taxed at 60%.
Let’s take the example of someone who has a salary of £100,000 and receives a £1,000 bonus. This sounds exciting, until they receive their payslip:
- The additional £1,000 is taxed at the higher rate of 40%, meaning they are left with £600.
- As the bonus takes their income over the £100,000 threshold, they also lose £500 from their tax-free Personal Allowance (£1 for every £2 from £1,000 equals £500). Therefore, £500 more of their income will also be taxed at the higher rate of 40%, costing them a further £200.
- As a result, the £1,000 bonus has succumbed to £600 worth of tax, leaving just £400. The individual in our example has been taxed an effective rate of 60%.
According to Saltus, a financial planning and private wealth management firm, this is what is deemed the 60% tax trap.
Using your pension
Luckily, there is a tax-efficient way that can help you avoid this tax trap, by contributing to your pension. With some clever financial planning, you can reduce your taxable income and regain your tax-free Personal Allowance.
Using the example above, if the £1,000 bonus was contributed to a pension pot instead, then the money would benefit from the higher rate tax relief of 40%. What’s more, it takes the individual’s taxable income back down to £100,000, meaning they regain their tax-free Personal Allowance of £12,570.
Using your pension is a great solution to this tax problem, but also can significantly increase your retirement pot.
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A pension planning strategy can be highly beneficial for high earners, to help take control of your taxes. However, the numbers involved can be quite complicated. So, it is always best to consult with a financial adviser, who can examine your financial situation and create a bespoke, tax-efficient strategy.
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.
