The 60% Income Tax Trap
The bit of earnings between £100,000 and £125,000 is one of the most highly taxed bits of income. Are you caught out by this effective tax rate of 60%?
Not only do you pay 40% tax on this band of icome, but for every £2 earned over £100,000 you also lose £1 of your personal allowance. Therefore if you earn £125,000 or above, your personal allowance will be completely lost.
Losing Your Personal Allowance
For example, if you earn £100,000 and you receive a salary increase or bonus of £10,000, these additional earnings above £100,000 would be taxed at 40%, but you would also lose £5,000 of tax free income from your personal allowance. This effectively means that this £10,000 is also taxed again at 40% and you suffer an effective tax rate of 60% on the earnings above £100,000.
If you are in a position where your earnings are likely to go over £100,000 and you do not need the extra net income, one way to maximise tax efficiency could be to pay these additional earnings into a pension instead by way of salary exchange.
Using Pension Contributions to Regain the Personal Allowance
Salary exchange, or salary sacrifice as it is sometimes known, allows you to exchange part of your salary and/or bonus in return for your employer paying the sacrificed amount as an employer pension contribution.
Not only may you avoid paying additional tax at 40%, if this gets your salary below £100,000 it also preserves your personal allowance – effective tax relief of 60%.
If the contribution is made as an employer’s contribution you can also save the 2% employee National Insurance contribution on this bit of salary and if your employer is prepared to, they could also add the NI that they would save on the sacrificed earnings (13.8%) into the pension as well – further enhancing the tax saved.
Getting your employer to make pension contributions instead of you through salary exchange may also benefit you at other income levels.
This article is for information purposes only. For more information about the ideas raised or for specific advice regarding your circumstances, please contact one of our advisers.