You’ve just received a £1,000 bonus from your employer. That sounds like great news, doesn’t it? But if you’re earning more than £100,000 you could be caught out by the 60% tax trap. And you wouldn’t be alone, as a lot of unsuspecting high earners see their income effectively taxed at a rate of 60%.
However, it’s not all bad news, as fortunately there is a simple and tax-efficient way to avoid this tax trap — through your pension contribution.
Read on to discover the expert’s approach to steer clear of the 60% tax trap through some clever financial planning.
Understanding income tax rates
In order to understand how the 60% tax trap works you first need to have a knowledge of the income tax rates for England, Wales, and Northern Ireland, and the personal allowance.
Your tax-free personal allowance for the tax year 2021/2022 is £12,570. This is the amount of income you do not have to pay tax on. The rest of your income is taxed based on the following rates:
- Basic tax rate of 20% on earnings £12,571 to £50,270
- Higher rate of 40% on earnings £50,271 to £150,000
- Additional rate of 45% on earnings over £150,000
However, when you earn over £100,000, your personal allowance is reduced, gradually cut by £1 for every £2 of additional income. As a result, when your income reaches £125,140, you’ll lose your personal allowance completely, and in effect, start paying the higher rate of tax much sooner.
How you can fall into the 60% tax trap
Let’s look at our previous example, where you have received a £1,000 bonus on top of your salary.
First of all, this bonus will be taxed at the higher rate of 40%, costing you £400 and leaving you with £600. As you have exceeded the £100,000 threshold, you will also lose £500 of your personal allowance. That £500 of your income will then also be taxed at 40%, costing you a further £200.
Taking this all into account your £1,000 bonus is effectively taxed at 60%. You’ll be left with just £400 after paying £600 in tax.
This is just one example. You’ll find the impact worsens, the higher you earn over £100,000.
Using your pension to get your money back
By simply using your pension contributions, you can, in fact, avoid the 60% tax trap. If done effectively and correctly, this can help you reclaim your tax-free personal allowance, and also receive tax relief on the amount you pay into your pension.
Let’s imagine you are earning £125,140. You have therefore lost your entire tax-free personal allowance. However, with the help of expert financial planning services, you decide to contribute £20,112 to your pension.
The government will pay £5,028 in basic rate tax relief, straight into your pension. This means your total pension contribution is £25,140. A further £5,028 can be claimed in higher rate relief on your tax return.
You’ll also regain your full £12,570 personal allowance, saving you a further £5,028 in tax, and a total benefit of £15,084.
Through your pension contributions, not only do you make the most of the higher tax rate relief of 40%, but it also takes your annual taxable income back down below the £100,000 threshold and avoids the dreaded 60% tax trap.
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To truly make the most of your pension, and maximize your tax savings, it is always best to consult a financial adviser, who can guide you through such financial challenges as a high earner.
Disclaimer:
Information is correct to the best of our understanding as at the date of publication. Nothing within
this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less
than you invested.