A quick check with HMRC will confirm that Income Tax is charged at 0%, 20%, 40% or 45%, depending on your income for the year. The rates are marginally different in Scotland, but wherever you look, there isn’t a published rate of 60%, however much you earn.
However, if there’s one word to describe the UK tax system, it’s ‘complicated’ with plenty of scope for misunderstanding and expensive oversights.
One prime example is the 60% tax trap. The reason you won’t find it published in any HMRC guidance is because it’s an unofficial effective rate of Income Tax created by the tapering of the personal allowance for higher earners. The result is that those earning between £100,000 and £125,140 can end up paying 60% tax.
Thankfully, this particular sinkhole doesn’t affect many people. Nonetheless, it’s worth being aware of, because it highlights the broader problem of taxes that can appear by surprise and in different places.
“What the 60% rate represents is that sinkholes can appear anywhere – tax allowances change frequently and those changes can affect you,” warns Melloney Underhill, Marketing Insights Manager at St James’s Place Wealth Management. “For anyone earning more than £80,000 or so, the Chancellor has the opportunity every tax year to amend the threshold and the rules in a way that might have a big impact on you.”
Like most tax sinkholes, however, this particular problem can be avoided or mitigated with the right advice and a little bit of careful (and entirely legal) planning.
How the 60% tax trap happens
If you earn £100,000 or more, the rate of Income Tax you pay will be impacted by the gradual removal of the £12,570 personal allowance (the amount of income you can earn each year without paying Income Tax). It’s currently tapered away at a rate of £1 for every £2 you earn above £100,000.
This means that for every £100 of income between £100,000 and £125,140, you only get to take £40 home – £40 is deducted in Income Tax, while another £20 is lost by the tapering of the personal allowance. This amounts to a 60% tax rate on earnings within this range. Once you earn £125,140 or more, you don’t benefit from any personal allowance.
It may be that you are comfortable paying 60% tax – perhaps viewing it as a philanthropic gesture during difficult times. However, if you would prefer not to pay tax at 60%, there is a simple way to beat it.
Top up your pension
“The quickest and simplest way to reduce this proportional tax rate is to consider paying more into your pension to reduce the earnings that fall into that bracket,” suggests Underhill. This gives you the dual benefits of an Income Tax saving and a boost to your retirement fund.
Let’s say you get a £1,000 pay rise, which takes your taxable income to £101,000. If you pay that £1,000 into your pension, you won’t enter the 60% tax zone and you’ll get the benefit of a 40% top-up on your contribution, thanks to tax relief.
Depending on your scheme, that £1,000 may also be boosted further with additional employer contributions.
Currently, you can pay a maximum of £40,000 into your pension each year and still enjoy tax relief on your contributions.
Other ways you can use your pension to cut your tax bill
There are a number of ways in which topping up your pension can reduce the amount of tax you pay. This is because pension contributions deducted from your earnings will reduce your taxable income.
Middle-income households can increase pension contributions to prevent them entering the higher-rate tax band.
The high-income Child Benefit charge is a tax charge that is levied to households receiving Child Benefit where one partner has a net adjusted income of more than £50,000. This charge is another that uses tapering, with an extra 1% deduction of the amount of Child Benefit for every £100 of income over £50,000. However, once again, you can reduce its impact by increasing your pension contributions.
Talk to an adviser
This article gives an insight into the ways in which tax allowances can catch you unawares, and the consequences can be expensive if you aren’t prepared. Tax rules are complicated and change frequently, but you can be confident that an adviser will always be up to speed with the latest legislation.
By speaking with a St. James’s Place Partner, it’s often possible to swerve around any sinkholes or legally mitigate them.
As Underhill says: “You are on your own career and earnings path, driven by so many other factors, not just tax, but you still need to be mindful of how the Chancellor can affect your journey. Advisers are there to work with you and help you navigate the ever-changing landscape.”
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time. Tax relief is generally dependent on individual circumstances.