The quirks that mean you can pay up to 200,000% in tax – and how to avoid them

Laura Suter
28 March 2019

The loss of some benefits and allowances can potentially result in effective tax rates way above the highest income tax band in the UK:

Loss of benefit / allowance

Maximum effective tax rate

Child benefit

57.89%

Personal allowance

60%

Personal savings allowance

22,500%

Married couples allowance

23,800%

Tax free child care

200,000%

Laura Suter, personal finance analyst at investment platform AJ Bell, comments:

“The highest rate of income tax in the UK is normally 45% for people who earn £150,000 or more each year. But the convoluted and complex way our tax system is run means that people can actually pay a far higher effective rate of tax than this when they hit certain circumstances. The most extreme cases are where there is a cliff edge and just £1 of extra income can result in losing a tax break, which creates an eye-watering effective tax rate on that £1 of income.  

“Clearly these effective rates of tax will be lower if you are more than £1 over the cliff edge but the principle is that a small increase in salary could be more than cancelled out by an increase in tax if you’re not careful. The good news is that some smart planning can help to mitigate the effects.”

Child benefit 

"As soon as parents earn more than £50,000 they will start to see their child benefit taken away, at a rate of 1% for every £100 earned, before the benefit is completely wiped out when you hit earnings of £60,000. 

“A parent with two children will get £1,788.80 a year in child benefit, but for every £1,000 they earn over £50,000 they will lose 10% of their child benefit – so £178.88. These earnings will be in the 40% income tax bracket and once the loss of child benefit is factored in their effective tax rate is 57.89%*. 

“However, parents can get around this by increasing their pension contributions. Your salary after any pension deductions is what’s counted for the child benefit high income charge, so if you contribute enough to your pension to get your salary back to £49,999 then you’ll get the full child benefit again. Another option is to make charitable donations with the income over the £50,000 limit, which you’ll need to declare to HMRC on your tax return.

“However, the frustrating factor for many parents is that the rule applies if one parent is earning over £50,000, regardless of their partner’s income. So you could have both parents earning £48,000 each and have no problem, but if one earns £96,000 then you’ll lose the benefit and will struggle to bring your income down enough to get under the £50,000 limit.”

Personal allowance 

“Only around 3% of the population have income of £100,000 a year or more, but that group face a massive tax on the money between £100,000 and £123,700. This is because these earners lose their tax-free personal allowance, at a rate of £1 for every £2 they earn over £100,000. 

“So, for example, someone who gets a payrise from £100,000 to £110,000 will lose £5,000 of their personal allowance. They will be taxed at 40% on their payrise money, amounting to £4,000, and then taxed at 40% on their lost personal allowance, amounting to £2,000. This means they pay £6,000 on the £10,000 pay rise – an effective tax rate of 60%.

“From April the personal allowance will increase to £12,500, but this means the 60% tax rate will apply to all earnings from £100,000 up to £125,000. To get around this high rate you can make pension contributions equalling any salary over £100,000. By doing this your personal allowance will be reinstated and you’ll get 40% tax relief on your pension contributions too.”

Married couples allowance

“Married couples are eligible for a tax break so long as one of them earns less than the personal allowance, so £11,850 for this tax year, and the other half earns the basic-rate of tax, so less than £46,350. It means that the lower earning partner can transfer any of their unused personal allowance to their spouse – with a maximum saving of £238 in a tax year. 

“However, once the higher earning partner earns more than that £46,350 they can’t use the tax break, and lose it entirely. Assuming someone is getting the full £238 tax break a year and gets a payrise from £46,350 to £46,351, the effective tax rate is 23,800% (£238 of tax because of £1 of extra income).”

Personal savings allowance

“The Personal Savings Allowance was introduced in 2016 and gives basic-rate taxpayers their first £1,000 of savings income tax free, while higher rate tax payers get a £500 limit. However, once you move into the additional-rate tax bracket you lose that entire allowance. This means if you go from earning £150,000 to £150,001 you’ll lose the allowance. If you had £500 of savings income that was previously tax free, you’ll now be taxed at 45% on it – equating to £225 of tax. That makes the effective tax rate on your £1 salary increase 22,500%.”

Tax-free childcare 

“The Government has recently switched to a new childcare system, ditching the previous vouchers system in favour of a new tax-free childcare system. It means you can get up to £2,000 a year towards childcare each year, per child, with the Government paying £2 for every £8 you pay in – effectively giving you basic-rate tax back

“However, the scheme is only available for couples where both have an income of less than £100,000 – anyone earning more than this is cut off from using it. There’s a double hit for some of these high-earnings parents. If you were previously on the vouchers system and have opted to remain on them, you can continue, but if you’re new to the system or you move employers you’ll lose the right to access the vouchers system, and will not be able to access the childcare tax breaks at all. As with the child benefit rule above, a couple with income of £99,000 each would be eligible, but a couple where one earns £15,000 and the other earns £105,000 wouldn’t be.

“In the most extreme example, if your income rises to £100,001, you’ll lose the £2,000 benefit, equalling a tax rate of 200,000%. Anyone earning over the £100,000 limit can use pension contributions or gift aid to reduce their income below the threshold.”

*40% of £1,000 = £400 + loss of child benefit of £178.88 = £578.88 as a percentage of £1,000 = 57.89%

Laura Suter
Personal Finance Analyst
Laura Suter is personal finance analyst at AJ Bell. She is a multi-award winning former financial journalist, having specialised in investments. Laura joined AJ Bell from the Daily Telegraph, where she was investment editor. She has previously worked for adviser publications Money Marketing and Money Management, and has worked for an investment publication in New York. She has a degree in Journalism Studies from University of Sheffield.
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