As a high earner, you may be presented with great opportunities when it comes to your finances and investments. However, this also means you could face considerable financial challenges, especially concerning the growth of your wealth and the amount of tax you pay.
Seeking some expert financial planning advice is always the best option, in order to construct a robust financial plan and reduce your tax burden.
However, in this article, we’ll give you some insight into one of the methods used by the experts, to help avoid the notorious 60% tax trap.
Read on to find out more.
How can the 60% tax trap catch you out?
First of all, you need to understand income tax rates in England, Wales and Northern Ireland, which are categorised into the following bands:
- Personal Allowance — taxable income up to £12,570 = 0% tax rate
- Basic rate — taxable income of £12,571 to £50,270 = 20% tax rate
- Higher rate — taxable income of £50,271 to £150,000 = 40% tax rate
- Additional rate — taxable income over £150,000 is taxed at a rate of 45%
A Personal Allowance is not available if your taxable income exceeds £125,140. This is because, when your taxable income reaches £100,000, your Personal Allowance is gradually cut by £1 for every £2 of income earned.
Therefore, if you’re earning in excess of £100,000, and were to receive a bonus of £1,000 from your employer, this would be taxed at a rate of 40%, costing you £400 in income tax.
Furthermore, this bonus would take you over the £100,000 threshold, losing you £500 from your tax-free Personal Allowance (as explained above). £500 more of your income will also now be taxed at the higher rate of 40%, costing you a further £200.
You would have fallen victim to the 60% tax trap, with your £1,000 bonus taxed at an effective rate of 60% — meaning you would have paid £600 in income tax, being left with just £400.
However, there is a way to overcome this quirk in the tax system, with some clever financial planning, and by simply using your pension.
How to avoid the 60% tax trap using your pension?
The 60% tax trap can have a significant impact, but with some careful planning, you can reduce your taxable income and regain your tax-free Personal Allowance.
This can be achieved through your state pension contributions. For example, if you were earning £125,140, you would have lost your entire tax-free Personal Allowance. However, through the guidance of your financial adviser, you could decide to make a pension contribution of £20,112.
You can use your pension contributions to claim tax relief, therefore the government will apply £5,028 in basic rate tax relief to this contribution. This relief is paid straight into your pension pot and takes your total contribution to £25,140. A further £5,028 can also be claimed in higher-rate relief on your tax return.
As well as the tax relief applied, your contribution reduces your taxable income by £25,140. You’ll regain your tax-free personal allowance of £12,570, as your taxable earnings are now £100,000. This will save you a further £5,028 in tax.
Not only will you have avoided the 60% tax trap by contributing to your pension, but in this example, you’ll see a total benefit of £15,084.
In addition, if you’re pension contributions were to be made via salary sacrifice, National Insurance will also be saved, increasing the total benefit even further.
To ensure you have the most suitable financial plan for your personal situation and requirements, it’s worth taking the time to find the right financial adviser for you, who can offer guidance to rebuild your finances on such things as the 60% tax trap, and much more.