It’s often thought that the highest rate of income tax in the UK is 45% – but that’s not actually the case.
A quirk in the system means that anyone earning between £100,000 and £125,140 can find themselves paying a whopping 60% tax on this portion of their earnings.
That’s because when your taxable income is over £100,000, your £12,570 tax-free personal allowance tapers away at a rate of £1 for every extra £2 you earn.
In practice, this means that for every £100 of income you earn between £100,000 and £125,140, you only get to take home £40. This is because £40 goes to income tax, while another £20 is lost due to the tapering of the personal allowance.
It might sound like the very definition of a first world problem, but as the example above shows, a six-figure income can make paying tax more arduous. Our tax system is complicated to say the least!
Luckily, contributing to your pension can simultaneously reduce your income tax liability and improve your financial future.
How can I avoid the trap?
The easiest way to sidestep the trap is to pay more into your pension each year so that your earnings no longer fall into the bracket.
Not only does this help you save income tax – it also gives your retirement plans a boost.
Of course, you can also reduce your income below £100,000 by making a charitable contribution. You can get full tax relief on contributions you make to registered charities.
If you’d like to learn how to avoid the tax trap by topping up your pension, read on.
We claim back basic rate tax relief of £5,000 from HMRC on your behalf, and add it to your pension, bringing your total contribution to £25,000.
This impacts your taxable income in two ways.
1. You can claim another £5,000 in ‘higher-rate’ tax relief
You are entitled to claim the basic 20% tax relief from the government when you make contributions to your pension.
However, because the amount of tax relief you get is linked to the highest band of income tax you pay, higher-rate and additional-rate taxpayers can claim extra tax relief on top of the basic 20%.
Higher-rate taxpayers can claim a further 20%, while additional-rate taxpayers can claim an extra 25%.
2. Your adjusted income is seen as £100,000
Secondly, HMRC now sees your adjusted net income as £100,000 (total income minus total pension contributions) which means you get back your full personal tax-free allowance, reducing your income tax liability by a further £5,000.
See for yourself how you could pay less income tax by increasing your monthly pension contributions using our pensions calculator.
If you’re a high earner, but you’re not sure whether the 60% tax trap applies to you, you may want to speak to one of our financial advisers.
Just get in touch – this is what we’re here for. All you need to do is book a free call with our friendly wealth services team today.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. A pension may not be right for everyone and tax rules may change in the future. If you are unsure if a pension is right for you, please seek financial advice. Please note that during any transfer, your investments will be out of the market.