Archived article: Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Like the sound of keeping more of what you earn and beating the worst tax traps in the UK system? Then read on to discover the power of pension contributions.
Rising incomes coupled with frozen thresholds and allowances mean the taxman is set to rake in an extra £20 billion this tax year, according to HMRC statistics. A further 500,000 people will be dragged into the 40% tax bracket, meaning over 8.3 million people are now higher or additional-rate taxpayers. This is an increase of over 45% since the start of the tax threshold freeze began in 2022.
Income tax bands
Once you move over the £50,270 mark, your next pound of earnings is hit with a 40p deduction, meaning you see much less of any pay rises or bonuses going forward.
The tax-free personal allowance starts at £12,570 but reduces by £1 for every £2 of adjusted net income over £100,000. It is lost completely where income is over £125,140.
After any tax-free personal allowance, income tax is paid on the following bands of taxable income.
| Income slice | Income tax rate |
|---|---|
| Up to £37,700 | 20% |
| £37,701 - £125,140 | 40% |
| Over £125,141 | 45% |
*Tax rates, and thresholds are different for Scottish taxpayers
Tipping into higher rates of income tax on your earnings also affects how much interest you can keep tax-free, outside of ISAs. The personal savings allowance is set at £1,000 for basic rate (20%) taxpayers, but halves to £500 for higher rate taxpayers, before disappearing altogether for additional rate taxpayers.
But thanks to pension tax relief, paying into your pension can move you out of a higher tax band as well as boosting your retirement savings.
How does it work?
Let’s consider Simon, who earns £52,000. He pays 20% income tax on his salary between £12,570 and £50,270 and 40% on the top £1,730.
If he paid £1,384 of his post-tax income into a pension, this would automatically be topped up by basic rate tax relief to £1,730 in his pension. He would be able to claim an extra £346 in higher rate tax relief directly from HMRC, reducing the cost of the contribution to £1,038. It also moves him out of the higher rate tax band and means he keeps his full £1,000 personal savings allowance for interest.
Parents can claw back child benefit
The potential benefits don’t stop there. Child benefit is now withdrawn at a rate of 1% for each £200 of adjusted net income over £60,000, meaning eligibility for child benefit is lost entirely where one partner earns £80,000 or more.
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.
But pension contributions can be deducted when working out your adjusted net income, as well as the total value of donations to charity that qualify for gift aid (including the gift aid).
If a parent earning over the £60,000 mark can pay into their pension, not only will they boost their retirement pot, they’ll get up to 40% tax relief on what they pay in and clawback their full child benefit payments, too.
The £100,000 tax trap
Although we outlined the standard income tax rates above, you can face an effective tax rate of 60% on some of your income. This is sometimes referred to as the £100,000 or 60% tax trap.
It happens because people earning over £100,000 start to lose their tax-free personal allowance. The impact of this loss plus the extra income tax means an effective rate of 60% on the band of earnings between £100,000 and £125,140.
The trap – and how to beat it – is best illustrated with an example.
If Lydia earns £100,000, she will pay a total income tax of £27,338.40 over a tax year and keep her full personal allowance.
But if her earnings rose to £110,000, her tax bill would jump to £33,338.40. This is due to losing £5,000 of the tax-free allowance, plus 40% tax on the extra £10,000. The extra £10,000 income results in £6,000 more income tax, an effective rate of 60% on this slice.
Lydia could beat the trap by paying £8,000 into her pension instead. This would be topped up by basic rate tax relief of £2,000 automatically, meaning an extra £10,000 in her pot. This reduces Lydia’s taxable income back down to £100,000, meaning she retains her full personal allowance and reduces her tax bill by £6,000. The £10,000 extra in her pension pot effectively costs her just £4,000 from her original post tax pay – a tax relief boost of 60%!
Charlene Young: Senior Pensions and Savings Expert
Charlene Young is AJ Bell’s Senior Pensions and Savings Expert. She joined AJ Bell in 2014 from a wealth management firm where she worked with private clients and small businesses as a financial planner.
Charlene...
