Income tax traps and how to transform them

Article written by Matt Coppin, Wealth manager adviser approved by the FCA

There are various situations in which the UK’s complex tax system leaves employees paying more tax than what they should without even being aware. We have highlighted below three common “tax traps”:

The 60% tax trap if you are earning £100,000+

Most people have a tax-free personal allowance of £12,570, meaning that no tax is paid on the first £12,570 you earn. However, when your earnings are over £100,000, HMRC will start reducing your personal allowance by £1 for every extra £2 you make.

Therefore, if you earn between £100,000 and £125,000, you could find yourself paying 60% tax on this bracket’s earnings.

How could I change that?

The 60% tax trap is very common if you are earning £100,000+.

A simple way of managing this issue is by exchanging some of your earnings/salary and agreeing with your employer to pay this to you in pension contributions instead. This mechanism is known as Salary Exchange or Salary Sacrifice.

If you reduce your taxable income under £100,000 through Salary Exchange, you will not pay the extra tax. Moreover, you get the full level of tax relief applied immediately on your pension contributions, and you might not even need to complete a tax return.

Let’s look at an example…

If Mary earns £110,000 p.a., she is £10,000 over the limit where tapering of the personal allowance starts to apply.

If she makes a £10,000 pension contribution through Salary Exchange, her taxable income will not reach £100,000, and her personal allowance won’t be reduced.

 BeforeAfter exchange
Gross salary£110,000.00£100,000.00
Tax-free allowance£7,570.00£12,570.00
Income tax£33,432.00£27,432.00
NI Contribution£6,079.00£5,879.00
Worker pension contribution£8,000.00
NET pay£62,489.00£66,689.00

As per the above table, Mary’s NET pay would increase by £4,200:

  • £2,000 of tax saved by not having the personal allowance reduced
  • £2,000 extra tax relief would be applied immediately
  • £200 would be saved on NI contributions

An extra £ 1,380 could go into her pension contribution if the employer decides to reinvest their NI savings.

The Child Benefit tax trap if you are earning £50,000+

If you receive Child Benefit and either/both of the couple have earnings above £50,000, you might need to pay back some of your Child Benefit through income tax.

For every £100 of income above £50,000 that is earned, 1% of the Child Benefit amount needs to be paid as High Income Child Benefit Charge.

How could I change that?

A simple way of managing this issue is by exchanging some of your earnings/salary and agreeing with your employer to pay this to you in pension contributions instead. This mechanism is known as Salary Exchange or Salary Sacrifice.

If you reduce your taxable income under £50,000 through Salary Exchange, you will not pay the High-Income Child Benefit Charge, and you will receive the Child Benefit in full.

Let’s look at an example…

If John earns £53,000 p.a., he is £3,000 over the limit where High-Income Child Benefit Charges apply.

If he makes a £3,000 pension contribution through Salary Exchange, his taxable income will not reach £50,000, and he won’t have to pay extra High Income Child Benefit Charge. Additionally, the pension tax relief would be applied immediately.

Reaching the 40% tax bracket if you are earning £50,270+

The tax rate goes from 20% to 40% for earnings above £50,270.

If you have income over this level, you will start to pay higher rate tax (40%) on earnings over this limit.

How could I change that?

A simple way of managing this issue is by exchanging some of your earnings/salary and agreeing with your employer to pay this to you in pension contributions instead. This mechanism is known as Salary Exchange or Salary Sacrifice.

If you reduce your taxable income under £50,270 through Salary Exchange, you will not pay 40% tax.

Let’s look at an example…

If Laura earns £51,520 p.a., she is £1,250 into the 40% tax bracket.

If she makes a £1,250 pension contribution through Salary Exchange, her taxable income will not reach £50,270, and her whole income would be back within the basic rate tax band (20% rate).

 BeforeAfter exchange
Gross salary£51,520.00£50,270.00
Income tax£8,040.00£7,540.00
NI Contribution£4,909.24£4,884.24
Worker pension contribution£1,000.00 
NET pay£37,570.76£37,845.76

As per the above table, the NET pay would increase by £275:

  • £250 tax relief would be applied immediately
  • £25 would be saved on NI contributions

An extra £172.50 could go into the worker’s pension contribution if the employer decides to reinvest their NI savings.

Learn more

Download the Husky for Everyone app for Android or IOS and use the Salary Exchange calculator to figure out your potential savings.

If you are an employer and want to see the impact of a salary exchange arrangement for your business and staff, you can use this calculator.

Contact us to know how you can easily implement Salary Exchange for your business.

Please note: To enter into this system, your employer must first offer Salary Exchange. If the salary exchange arrangement drastically reduces a person’s salary on paper it may affect their ability to obtain debt based on “affordability” i.e. a mortgage, and/or their ability to access certain tax credits or benefits, and potentially also their Death in Service cover. This is usually at the extreme end of the spectrum though, if someone was to exchange a lot of salary, but worth highlighting and checking first.

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