The hidden 60% tax rate – and how to avoid it

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.

The reason for the effective 60% rate is actually rather subtle. What happens is that the shrinking personal allowance drags down the threshold for higher-rate tax by a similar amount (while it’s commonly said that this year’s threshold for 40% tax is £50,270, this is true only for those who receive the normal personal allowance of £12,570; in fact the 40% threshold is £37,700 plus the personal allowance and the basic-rate band is always £37,700 wide).

So when, as someone whose salary is £100,000, you earn one extra pound, your own higher-rate band is widened at both ends: at the top because you’ve earned that extra £1, and at the bottom because the shrinkage of the personal allowance drags the threshold down. It’s wider at the top by £1 and at the bottom by 50p; if you tax £1.50 at 40% you get 60p. As your before-tax income went up by only £1 in the first place and your tax bill is 60p more, your effective tax rate is 60%.

In passing we might note that it’s just as well the personal allowance is not withdrawn at a rate of £1 for every extra £1 in income above £100,000. That would widen your higher-rate band by £1 at the top and £1 and the bottom; 40% tax on £2 is 80p, so the effective tax rate on the extra £1 of income would be 80%. Shrinking the personal allowance by £1.50 for every extra £1 in income would result in an effective tax rate of 100% (40% of £2.50 is £1).

Scotland has a plethora of tax rates but a similar principle applies. All tax thresholds are dragged down by the erosion of the personal allowance and the amount in pounds that each person pays in tax for each of these bands is the same (as long as their earnings cover each band in full). None of that changes when someone who earns more than £100,000 earns an extra £1. All that changes is how much of their income is subject to the rate that applies at £100,000, which in Scotland is 45%. Each £1 in extra income here widens that tax band by £1.50, as in the rest of the country, so the extra tax is 45% of £1.50, or 67.5p, an effective tax rate of 67.5%.

To such sky-high tax rates we can add 2% in National Insurance, so the final deduction from your pay packet comes to 62% in England, Wales and Northern Ireland or 69.5% in Scotland.

Incidentally, in England it’s also at £100,000 a year that working parents lose entitlement to 30 hours a week of free childcare, on the basis of their or their partner’s ‘expected adjusted net income’, so there may be even more reason to reduce that figure by making pension contributions. Different childcare schemes and eligibility rules apply in Wales, Scotland and Northern Ireland.

In all parts of the UK the 60% or 67.5% band ends at £125,140. At this point, the £25,140 in earnings over £100,000 is enough to wipe out your personal allowance entirely. Above £125,140, the effective rate of tax on each extra £1 of income reverts to 45% in England, Wales and Northern Ireland, while in Scotland a 48% band starts at £125,140.

This does not mean, of course, that you can breathe a sigh of relief and forget about it in the knowledge that your marginal tax rate is ‘only’ 45% (or 48% in Scotland): you have still lost all your personal allowance, not to mention your childcare entitlement. We’ll now explain how you can get both of them back.

What is this legal way to avoid the 60% tax?

In a word: by making pension contributions. Paying money into a pension reduces your effective taxable income and, if your pension contributions reduce your adjusted net income to less than £100,000, your personal allowance will be restored in full. 

The principle is simple, the nuts and bolts less so. Let’s 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.

And how does using previous years’ pension allowances work?

Taxpayers are allowed to make pension contributions not just from their annual allowance for the current tax year but with those of the three previous ones too, as long as they have unused pension allowance from those years and meet a couple of other conditions. This is known as the ‘carry forward’ scheme.

This means that someone who earns £200,000 could reduce this year’s taxable salary all the way down to £100,000 and therefore have their full personal allowance restored and avoid the 60% tax trap in its entirety (as well as the 45% tax band and the loss of childcare).

To do so, they would first make an £80,000 contribution to their pension, knowing that HMRC will top it up to £100,000 thanks to basic-rate tax relief (for a non-workplace pension). On their tax return for this tax year, they would state that they are paying £100,000 into their pension (using this year’s full £60,000 annual allowance plus £40,000 from an earlier year). The earliest tax year they can use is 2023-24 and, if in that year they have £40,000 of unused pension allowance, they must use it all, rather than any unused allowance from a more recent tax year.

Those with very high incomes need to watch out for a rule under which their annual allowance for pension contributions is reduced. Known as the ‘taper’, it reduces your annual allowance by £1 for every £2 of adjusted income above £260,000 until the minimum allowance of £10,000 is reached at £360,000.

The rules are extremely complex but, in summary, if you think you have earned more than £260,000 in this tax year or in any of the three previous tax years, you could be caught by the taper. You can read more about this in our guide to the ‘tapered’ annual allowance. Alternatively, in view of the potential savings and the potential costs of making a mistake, it may be worth seeking help from a qualified financial adviser, either from Fidelity or elsewhere.

No matter what your salary, if you want to use unused annual allowance from previous years you must have earned enough in the current tax year to cover the entire contribution and you must have been a member of a pension scheme in every previous year you want to use, even if you did not make any contributions in those years.

Fidelity has published a guide to the carry forward scheme and there is also a tool that can help you work out if you have unused annual allowance on the government’s website.

• Read: Carry Forward and save more in our pension

Note that the use of previous years’ pension allowances does not allow you to avoid the 60% tax band in those years, if you were caught by it; they can help you avoid it only in the current tax year.

For simplicity, the examples above refer to salary or taxable income. Strictly speaking, the personal allowance taper is tested by reference to a defined term called ‘adjusted net income’. This is broadly your total taxable income before personal allowances, less certain deductions such as grossed-up pension contributions and Gift Aid. You can read more on HMRC’s guidance here: Personal Allowances: adjusted net income.

It’s not necessary to advise HMRC if you’re using previous years’ pension allowances, although it would be sensible to keep records in case of any queries from the taxman in the future.  

If you’ve got pensions spread across different providers, moving them to Fidelity’s Self-Invested Personal Pension (SIPP) could help you take control and get your money working harder.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

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