How to avoid the 60% tax trap that impacts high income earners
A quirk in the tax system means that anyone earning between £100,000 and £125,140 can find themselves paying an effective tax rate of 60% on this portion of their earnings.
This is 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 higher rate income tax, while another £20 is lost due to the tapering of the personal allowance.
How can I avoid the trap?
One tax-efficient way to respond to the tax 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.
For example, if you earn £125,000, and decide to put £20,000 into a Personal Pension with us, we will claim back basic rate tax relief of £5,000 from HMRC on your behalf and add it to your pension. This will increase your total contribution to £25,000.
This impacts your taxable income in two ways.
- 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 taxable income is viewed as £100,000
Secondly, HMRC now sees your taxable 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. If your personal pension contribution is £25,000, it comprises your own contribution of £20,000 plus £5,000 from basic rate tax relief.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with J.P. Morgan Personal Investing can go down as well as up and you may get back less than you invest. Pension eligibility rules apply. Tax rules vary by individual status and may change. This is general information, not personalised tax advice. If you are unsure if a pension is right for you, please seek financial advice.