The marginal 60% tax trap

...and how to offset it

Once taxable income breaches ￡100,000, you become subject to an effective 60% income tax on the next ￡25,140. However, this can be mitigated via pension contribution.

The 60% tax trap – what is it?

It arises due to the tapering of your tax-free Personal Allowance, once income exceeds ￡100,000

UK taxpayers are entitled to a tax-free Personal Allowance of ￡12,570. That is, the first ￡12,570 of taxable income, whether that be from salary, self-employed income, dividends, interest, etc., is completely tax-free.

However, that Personal Allowance is gradually reduced, at a rate of 50p for every ￡1 that taxable income exceeds ￡100,000 (down to zero once income exceeds ￡125,140).

This gives rise to an effective 60% tax on income between ￡100,000 and ￡125,140 – the standard higher rate of 40%, plus an extra 20% due to the effect of the Personal Allowance taper.

How pension contribution can help

…giving rise to an effective 60% tax relief

The key is that the tapering of the Personal Allowance is based on so-called adjusted net income, which is calculated as total taxable income before any personal allowances, and less certain tax reliefs, e.g. trading losses, donations to charity, and gross pension contributions.

Focussing on the latter, this means you can bring your adjusted net income down by making a contribution to your pension, and the tax benefits in doing so are stellar.

This is best explained by way of an example:

Kate has taxable income of ￡125,000 per year and is therefore subject to an effective 60% income tax on the last tranche of ￡25,000.

An option here (subject to affordability and her wider circumstances) would be to make a personal pension contribution of ￡25,000:

• In practice, she would actually pay-in ￡20,000; the pension provider would subsequently and automatically claim basic rate tax relief (20%) on her behalf, crediting the plan with ￡5,000,
• As a higher rate taxpayer, Kate would later reclaim an extra 20% / ￡5,000, upon the submission of her tax return (where she would need to detail the gross pension contribution),
• Plus another 20% / ￡5,000 due to the reinstatement of her Personal Allowance, as adjusted net income has been reduced to ￡100,000.
• Combining the above, and once all tax relief has been granted, the effective cost to Kate of a ￡25,000 gross pension contribution is ‘just’ ￡10,000. That represents an effective 150% return on tax relief alone.

Disclaimer: Pensions cannot be accessed until so-called Minimum Pension Age (currently 55 but due to rise to 57 from 2028). When investing, the value of investments, and any income from them, can go down as well as up, and you may get back less than you invested. Levels, bases of, and reliefs from taxation may be subject to change, and their value depends on the individual circumstances of the investor.

It’s important to note that this doesn’t just apply to those with earnings between ￡100,000-125,140 (i.e. the lower and upper thresholds for the reduction in one’s Personal Allowance). It’s also relevant for those earning above ￡125k and with available annual allowance (and surplus cash) to reduce their adjusted net income below ￡125,140.

In this instance, they would receive 45% tax relief (additional rate) on the first tranche of pension contribution, before accessing 60% relief as per the example above.

As good as it gets?

In certain circumstances, the potential tax benefits are higher still

60% tax relief / a 150% effective return is pretty good. But in certain circumstances, the tax benefits are actually greater still.

This is relevant for those with young children and relates to the availability of tax-free childcare (worth up to ￡2,000 per year, per child under 11) and 30 hours of free childcare (currently for children between 3-4 years old, but due to be extended).

In both instances, eligibility depends on adjusted net income, with a cliff-edge reduction once this breaches ￡100,000. In turn, the potential tax benefits of reducing income below ￡100,000 can be monumental – this warrants another blog in its own right (#cliffhanger), but let me know if you want to discuss this in the interim.