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How to avoid the 60% tax trap

Lee Mannion | Wednesday 22nd February, 2023

Although we may not always appreciate it, tax is part and parcel of earning in the UK. However, if you're a higher earner, you may end up paying even more tax than you realise.

As you begin earning above £100,000 you start to enter a new realm of financial complications. Time to shed light on a tax law quirk that brings unpleasant surprises to a large number of unwary taxpayers every year.

This is the 60% tax trap and how you can avoid it.

What is the 60% tax trap?

Before delving into the 60% tax trap, you must first be familiar with the UK's income tax rates and thresholds. Here's a quick recap of the tax rates and brackets for 2022/23:

table showing 2022/23 uk tax band and rates

The tax trap has to do with your Personal Allowance. Today, the regular Personal Allowance is £12,570. This is the amount of income that is exempt from taxation.

However, if your income exceeds £100,000, your Personal Allowance is reduced by £1 for every £2 of income above that £100,000 threshold.

This implies that if your income exceeds £125,140, you lose your Personal Allowance entirely and begin paying the higher tax rate on your income considerably sooner.

Consequently, due to tapering restrictions and the steady elimination of the personal allowance, the actual amount you're taxed may reach 60%. This affects anyone with a taxable income between £100,000 and £125,140.

due to the tapering personal allowance, anyone earning £125,140 a year is taxed 60%

How pensions help avoid the 60% tax trap

Often, the most effective strategy to avoid the 60% tax trap is to invest your earnings into your pension.

Here’s the clever part: just as exceeding £100,000 in income results in a double tax hit, deciding to make pension contributions has the opposite effect.

It allows you to claim tax relief on the amount you contribute to your pension while also reducing your taxable income - allowing you to recover part of the personal allowance you just lost.

Let's assume that you earn a £100,000 salary and have been handed a £1,000 bonus. In addition to being taxed at a rate of 40% (leaving you with £600), this incentive eats up £500 of your tax-free personal allowance.

Plus, this £500 will be taxed at a rate of 40%, costing you an additional £200. When all factors are considered, that £1,000 bonus has cost you £600. You have paid an effective tax rate of 60%.

by putting money in your pension, you reduce your income on paper, helping you avoid the 60% tax bracket

The impact of this tax trap increases significantly once your earnings exceed £100,000. Here's where your pension comes in.

If you are earning £101,000 and put £1,000 into your retirement savings via a salary sacrifice pension, not only does your money receive a 40% higher rate of tax relief, but it also reduces your yearly income back below the £100,000 level and out of the dreaded 60% tax bracket.

As a side note, your pension also provides a great way to keep your entire bonus tax-free.

An example of avoiding the 60% tax trap.

If someone earns £110,000 per year, then they are £10,000 above the threshold at which the personal allowance begins to be reduced.

However, if the employee contributes £10,000 to her pension through salary sacrifice, their taxable income will not exceed £100,000, and the personal allowance remains untouched.

table comparing net pay with a regular pension contribution vs a salary sacrifice pension scheme for someone earning £110000

As shown in the table above, the employee’s net salary would rise by £4,200 when they use a salary sacrifice pension scheme. This comes from:

  • £2,000 in tax savings from stopping the personal allowance reduction
  • £200 savings on your National Insurance contributions
  • £2,000 in extra tax relief from your pension contribution

Other ways to avoid the 60% tax trap

Your pension isn't the only way to avoid the trap. There are multiple ways to leverage salary sacrifice to help trim your tax bill.

Salary sacrifice lets you give up a portion of your pay to obtain a comparable benefit - meaning you're still enjoying your full compensation while, at the same time, reducing your taxable income. Here are a few examples available at many companies in the UK.

Cycle to work

One popular salary sacrifice option is a cycle-to-work program.

Here you give up part of your salary (just like with a pension) to 'purchase' a bicycle.

If a high-earner sacrificed £1,000 via a cycle-to-work program, they could actually take home an extra £400 in their payslip. Not to mention getting a bike worth £1,000!

If an employer applies for FCA authorisation, it's also possible to add bikes worth more than £1000.

Childcare vouchers

With this arrangement, you allocate a portion of your salary in exchange for tax-free daycare vouchers. There is a limit on the number of vouchers that may be claimed, dependent on income.

Prior to April 2011, higher-rate taxpayers who enrolled in a childcare voucher system were eligible for a monthly payment of £243.

Those who joined after that date have a monthly restriction of £124. Taxpayers at the basic rate may still receive up to £243 per month.

Low-emission cars

If you lease an ultra-low emission corporate vehicle via salary sacrifice, you can save roughly 30% of the total cost.

Again, any salary you put towards this helps reduce your taxable income.

Just remember to choose your vehicle with extreme caution since automobiles with greater emissions may incur a tax of up to 37%.

Avoiding the 60% tax trap

Without a doubt, using your pension is an excellent way to escape the 60% tax trap and may also greatly enhance your retirement savings.

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