Budget or not, income tax is rising - but you can act

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

To put it another way, someone earning twice the average wage in 2000 would have paid almost no higher-rate tax. Today, had their pay risen in line with average wages, 36% of their income would fall into the 40% rate.

As well as taking much more money off workers than would have been the case if thresholds had risen to match wages, fiscal drag has created many more higher and additional rate taxpayers overall. You can see in the chart that the effects of fiscal drag have accelerated over the past six years. That’s due to thresholds being frozen since 2020, but also the fact we have seen wages rising much more quickly as well.

The table below shows the effect of fiscal drag recently. The number of higher-rate taxpayers has jumped 78% since 2020. The number of additional-rate payers has risen 184%.

In total 8.31m people now pay either higher or additional-rate tax - more than 21% of all taxpayers.

‘60%’ tax and the hidden fiscal drag trap

While the highest income tax band is 45% there is effectively a ‘60%’ band between £100,000 and £125,140. This is because, once you reach £100,000, each extra pound of income results in the loss of 50p of your tax-free personal allowance, which is the first £12,570 of your income. These figures are for England, Wales and Northern Ireland; in Scotland tax rates are higher, taking the effective rate to 67.5%.

• Read how the 60% tax trap works - and how to avoid it - here

This £100,000 threshold for losing your personal allowance is another that has been frozen - although you are very unlikely to hear mention of that come Budget time. Figures on the effect of this freeze are harder to come by, but we can gauge its impact when we consider that the tapering of the personal allowance was first introduced in 2010, with the £100,000 threshold set at that point.

Had the £100,000 threshold risen in line with wages it would now sit around £163,000 today.

How to escape the threshold freeze

Making pension contributions is the simple way to mitigate the effects of frozen tax bands. Paying money into a pension reduces your effective taxable income so the amounts falling into the higher band reduce. It’s particularly effective if you are being hit by the £100,000 threshold and the 60% effective tax rate arising from losing your personal allowance. If your pension contributions reduce your taxable income to less than £100,000, your personal allowance will be restored in full.

For example, say you earn £110,000 and want to bring your taxable income back to £100,000 exactly to extricate yourself from the 60% tax band. You might imagine that you have to write a cheque for £10,000 to a pension company but in fact £8,000 will suffice. This is because the pension company will automatically top up your contribution by £2,000, which represents basic-rate tax relief from HMRC. So, the amount that ends up in your pension once that tax relief is credited to your account is £10,000.

You’ll need to fill in a tax return too because that’s how you claim the rest of the tax relief you are due, which will be paid directly to you as a refund by HMRC. The tax office will compare the tax you are actually liable for with what you have already paid and refund the difference, so the extra you paid, thanks to the 60% rate, will be accounted for automatically.

The method of making pension contributions described above applies to non-employment schemes. For employment or workplace schemes the situation is different and you should check what to do with your company or its pension scheme.

• Open a Fidelity Self-Invested Personal Pension (SIPP)
• Read: 3 steps to avoid higher rate tax in retirement
• Read: The hidden 60% tax rate and how to avoid it
• Read: How to ensure your savings beat inflation in 3 charts