How to avoid paying income tax at 60%

With the recent announcements in the Spring Budget and the increase of the annual allowance to £60,000 gross, pensions are now back in the forefront of the news and headlines.

There are a number of well-known tax benefits to pension contributions including income tax relief on contributions, no capital gains tax on investment growth and inheritance tax efficiency with pensions being held outside of your taxable estate.

In addition to the above, higher rate taxpayers are able to claim an additional 20% income tax relief via their self-assessment tax return.

In April 2010, the Government introduced a threshold of £100,000 above which £1 of the personal allowance would be lost for every £2 of income received. This means that for income levels above £125,140 per annum, you are no longer entitled to the personal allowance. As you are now paying higher rate tax on an additional £12,570, there is an effective tax rate of 60% on income between £100,000 and £125,140.

The £100,000 income threshold has stayed at the same level since it was introduced in April 2010. With wage levels rising in an attempt to negate inflationary pressures, the number of UK taxpayers subject to this effective tax rate is increasing on an annual basis.

ONS statistics confirm that when this threshold was introduced in April 2010, there were 319,000 UK taxpayers earning between £100,000 to £150,000 gross per annum. By the 2020/21 tax year, this figure had increased to 570,000 UK taxpayers. With a further 1,170,000 UK taxpayers earning between £70,000 and £100,000 gross in the 2020/21 tax year, the figure subject to the £100,000 threshold is likely to increase exponentially moving forward.

So how can pensions be used to avoid this 60% effective tax rate?

The £100,000 threshold is measured against your adjusted net income. The adjusted net income is your total taxable income less certain tax reliefs such as charitable donations made through Gift Aid and gross pension contributions into relief at source and net pay pension arrangements.

Therefore, by making a personal pension contribution it is possible to reduce your adjusted net income below the £100,000 threshold. This is shown in the example below:

From a contribution of £25,140 gross, you would receive tax relief savings of £15,084. Providing an effective tax relief of 60% (£15,084 / £25,140).

If your employer offers salary sacrifice and is willing to pass on their National Insurance saving then it is possible to achieve an even greater effective tax relief. This is demonstrated below:

In the above example, you would receive an additional employer pension contribution of £28,609 with only a reduction in net income of £9,554. This equates to an effective tax relief of 67% (£19,055 / £28,609).

The story becomes even brighter for those earning £100,000 to £125,140 who are also entitled to tax-free childcare of £2,000 per annum (£4,000 per annum for those with a disabled child).

This tax relief is also lost where either parent has an adjusted net income over £100,000. The entitlement to tax-free childcare can be restored in the same way as the personal allowance by making a pension contribution into a relief at source or net pay arrangement to reduce the adjusted net income below £100,000.

For those parents eligible for tax-free childcare with an income between £100,000 to £125,000 who are able to benefit from salary sacrifice, it is possible to achieve an effective tax relief rate of 74%. When factoring in that current legislation permits 25% of your pension to be paid as a tax-free lump sum, this makes pension contributions for this small group particularly attractive.

Given current market and economic conditions, there may be a number of people who are this year receiving large pay rises or bonuses who may unknowingly be subject to the 60% effective tax rate and could benefit from the aforementioned pension planning. 

This article should not be construed as a personalised recommendation. The most suitable solution for you will depend on your own personal circumstances. No action should be taken without seeking further formal advice.

MHA Moore and Smalley is the trading name of Moore and Smalley LLP. Moore and Smalley LLP is regulated by the Financial Conduct Authority, FCA registration number 448716.