Beat the £100,000 tax trap cost that could cost parents tens of thousands

September marks the final phase in extending free funded childcare hours in England, which could save eligible working parents thousands of pounds a year. But the long standing £100,000 tax trap could mean this punishes higher earnings parents even further.

Parents might be able to re-arrange their finances to side-step the penalty by making modest pension contributions. This can improve their overall financial position as they regain lost childcare support and boost their retirement pots.

It all comes down to something the taxman calls ‘adjusted net income’.

How income affects access to childcare support

Families trying to work out how their earnings might impact access to childcare subsidies and child benefit should start by working out their individual ‘adjusted net income’.

Despite the name, ‘adjusted net income’ refers to all income that would be subject to tax, less certain reliefs. So not just earnings, but income from investments, savings and property too.

If a parent has adjusted net income of over £100,000 for a tax year, then their family will lose the following childcare offers*:

• All entitlement to tax-free childcare, worth up to £2,000 per child per year
• All of the 30 hours funded termtime childcare for 9-month to 3-year-olds
• Half of the 30 hours for children aged between three and four

Parents over the earnings limit will only be entitled to the universal 15 funded hours in term time for three- and four-year-olds.

As well as losing access to childcare subsidy schemes, their tax-free personal allowance starts to reduce too, meaning even more of their income is subject to tax.

They will also not be entitled to child benefit, which under the High Income Child Benefit Charge (HICBC) is removed entirely once one partner earns £80,000.

*In England only. Rules differ in Scotland, Wales and Northern Ireland.

How much high earners miss out on

There are three key child support payments that parents can obtain: tax free childcare, the ‘free’ hours childcare scheme, and child benefit.

While most working couples can access all three, the highest earners are ineligible for almost everything.

Once one partner earns over £100,000, families are no longer eligible for tax-free childcare, worth up to £2,000 per child.

Likewise, they can’t use the ‘free’ hours childcare funding which will be increased in September to 30 hours per week in term time for children from 9 months up to three years old. Their access to funding for children aged three to four is slashed from 30 to 15 hours as well.

Child benefit is also off limits for anyone earning over £80,000 – and if you do claim the money, you’ll need to repay it thanks to the HICBC.

In total, a family with two children aged 9 months and 2 years old could miss out on over £29,000 this coming academic year.

In contrast, moderately well-off families where the main breadwinner earns £60,000 could access all this support, with the figures illustrating how middle-income families have benefitted hugely from government reforms to child benefit and free hours childcare funding in the last couple of years, while the highest earners continue to be excluded.

The UK tax system operates primarily on individual earnings, not household income. It means these benefits are not available to a family with one partner earning just over £100,000 and another on £25,000, whereas if mum and dad make £60,000 each, they get the full package of support, giving them a higher family spending power.

Although the previous government hoped to reform the HICBC to base it upon household income, last year’s Budget dismissed the idea. The government said the reforms would eventually cost £1.4 billion if the threshold were increased to £120,000-£160,000 per household, rather than the current system of £60,000-£80,000 based on individual earnings.

How a £2,000 pay rise could cost you £27,000

The perfect way to illustrate the ‘cliff-edge’ nature of UK childcare funding schemes is to imagine a parent in this scenario with earnings of £99,000. If they were awarded a bonus of £2,000, bringing their total adjusted net income to £101,000, the warped rules mean this £2,000 pay rise ends up costing them over £27,000 thanks to a combination of taxes (see below) and the loss of childcare subsidies. That’s an effective penalty of well over 1000% on that extra money.

What’s astonishing is how much their salary would need to increase to get to the same post-tax income and value of childcare support as before. The breadwinner’s salary would need to increase to around £156,000 before the family got back to the same total disposable income as when the breadwinner was earning £99,000. This puts some parents in the ridiculous place where they are effectively worse off earning between £100,000 and £156,000 on paper.

Tax on earnings over £100,000

For high earning parents, the story isn’t just about the loss of childcare support. They’re also subject to the highest effective tax rate in the UK, thanks to the loss of their personal allowance.

Those with salaries up to £125,140 are theoretically taxed at a marginal income tax rate of 40%. But that doesn’t paint the full picture. In fact, the withdrawal of the personal allowance means a tax rate of the band of earnings between £100,000 and £125,140.

That’s because of the loss of the personal allowance, which is cut by £1 for every £2 of earnings over £100,000. It means there’s a strong tax incentive to reduce earnings below £100,000 anyway, with parents facing the double-whammy of lost childcare funding on top.

How pension contributions can help

Thankfully, there are options for avoiding such a penalty on earnings. Diverting money into your pension could leave you in a better overall financial position. 

If you are the high earning parent in our example, paying in just £800 to a pension would lower your adjusted net income by £1,000 (£800 plus automatic basic rate tax relief), getting you back the £27,000 and topping up your pension pot by £1,000, too.

That’s because along with tax relief, pension contributions also lower the ‘adjusted net income’ measure used to test your eligibility for tax-free childcare and enhanced free hours. It’s also the point at which you’ll start to lose your tax-free personal allowance at a rate of £1 for every £2 of income above £100,000.

If you’re able to pay more into a pension, you’ll come further away from the edge and have the benefit of boosting your pension pot at a cost of 60p to you for every extra £1 invested.