The 60% income tax trap*
It is widely believed that the highest income tax rate is currently 45%, paid only on an income in excess of £150,000. While this is true, some people may actually have an effective tax rate of 60& on part of their income.
Case study: salary increase over £100,000
Caroline has had a successful career as a shipping lawyer and has reached a salary of £100,000. She was delighted to learn that she was being promoted to a salaried partner with a 10% increase in her pay. However, the issue is that for every £2 she earns over £100,000, she will lose £1 of her personal allowance (so once her salary reaches £125,000, she will have no personal allowance). The following table illustrates the impact this has on her net pay:
| Before pay rise | After pay rise | ||||
| Salary range | Tax rate | Tax | Salary range | Tax rate | Tax |
| £0 to £12,500 | 0% | £0 | £0 to £12,500 | 0% | £0 |
| £12,500 to £50,000 | 20% | £7,500 | £12,500 to £50,000 | 20% | £7,500 |
| £50,000 to £100,000 | 40% | £20,000 | £50,000 to £110,000 | 40% | £24,000 |
| Lost personal allowance of £5,000 | 40% | £2,000 | |||
| Total tax | £27,500 | Total tax | £33,500 | ||
The table shows that although Caroline’s pay has increased by £10,000, her tax has increased by £6,000, which is an effective tax rate on this top element of her pay of 60%. This is triggered by the 40% tax on the lost personal allowance.
As Caroline is now earning more than £100,000, HMRC will also require her to complete a tax return.
As a solution, Caroline can make an additional pension contribution. If her employer’s pension scheme is a group personal pension and Caroline pays a net pension contribution in the tax year of £8,000, then with the addition of basic rate tax relief, this will increase to a payment into her pension of £10,000. Her “adjusted net income” will reduce to £100,000, so she will get back her personal allowance, and her basic rate band will grow by the amount of the contribution. Therefore, we now has the following tax rates:
| Salary range | Tax rate | Tax |
| £0 to £12,500 | 0% | £0 |
| £12,500 to £60,000 | 20% | £9,500 |
| £60,000 to £110,000 | 40% | £20,000 |
| Total tax | £29,500 |
Caroline pays £4,000 less in tax, but also receives the £2,000 top-up to the pension contribution, so the overall effect is an additional payment into her pension of £10,000 and a saving in tax of £6,000 (a 60% tax relief).
If her employer’s pension scheme is a trust-based scheme, then the payment of pension contributions are generally deducted before the calculation of tax. Therefore, paying a £10,000 contribution in the tax year effectively puts her tax position back to how it was before the pay rise.
Alternatively, Caroline may be able to use salary exchange to give up the pay rise, in return for the employer making the additional contributions into the pension scheme. The additional benefit of this approach is the additional saving of National Insurance contributions, which on a sacrifice of £10,000 would be an additional saving of £200.
Case study: discretionary bonus payment
Patrick is a Managing Associate earning £95,000. He has had a very busy year working on some major clients of the firm, giving great client service and advice; so the firm decides to reward Patrick for his exceptional performance by paying a discretionary bonus of £15,000.
As a result, Patrick will now earn £110,000 in the tax year, and therefore faces the same issue as Caroline.
| Before bonus | After bonus | ||||
| Salary range | Tax Rate | Tax | Salary range | Tax rate | Tax |
| £0 to £12,500 | 0% | £0 | £0 to £12,500 | 0% | £0 |
| £12,500 to £50,000 | 20% | £7,500 | £12,500 to £50,000 | 20% | £7,500 |
| £50,000 to £95,000 | 40% | £18,000 | £50,000 to £110,000 | 40% | £24,000 |
| Lost personal allowance of £5,000 | 40% | £2,000 | |||
| Total tax | £25,500 | Total tax | £33,500 | ||
The table shows that although the firm has paid Patrick a bonus of £15,000, he will pay an additional £8,000 in tax (an effective tax rate of 53.3%).
Again, a possible solution for this is for Patrick to make an additional pension contribution. This is achievable through a bonus sacrifice, and as the bonus is discretionary, this would simply need to be agreed at the time the bonus is being discussed. If Patrick sacrificed £10,000 of his bonus, his pay would reduce to £100,000 and his tax will be as follows:
| Salary range | Tax rate | Tax |
| £0 to £12,500 | 0% | £0 |
| £12,500 to £50,000 | 20% | £7,500 |
| £50,000 to £100,000 | 40% | £20,000 |
| Total tax | £27,500 |
Consequently, Patrick has additional net income of £3,000, but in addition, an extra contribution in his pension account of £10,000 and a saving of £200 in National Insurance costs. Overall, a total value of £13,200 and effective tax rate of 12%.
These case studies illustrate how tax-efficient pension contributions could help you achieve more at this pay point in situations where the loss of personal allowance increases the effective tax rate.
For more information, don't hesitate to get in touch with a member of our team.
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Robert J Young BSc FIA |
*These examples are fictional, but the content is based on various, real client experiences.