How to use your pension to beat the 70% tax trap

How would you feel about the taxman grabbing £7 in every tenner you earn on a portion of your hard-earned income? I’m guessing less than enamoured.

However, from April next year that’s the reality facing some workers who live north of the border.

In mid-December, Scotland’s deputy first minister, Shona Robison, unveiled a new 45% tax threshold that will hit the pockets of higher earners. Announced as part of the Scottish budget, the new “advanced rate” will apply to earnings between £75,000 and £125,140 and will come into effect from April 2025.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

In a further blow to those with big incomes, Robison said the top rate of income tax, paid by those who earn more than £125,140 a year, will rise from 47% to 48%.

The Scottish government estimates the new advanced rate will affect 114,000 workers, while a further 40,000 will pay the top rate of income tax.

On a brighter note, the starter, basic, and immediate-rate tax thresholds will increase in line with inflation, again from April.

What are the tax bands from April 2025?

Scotland’s income tax system is more complex than in other parts of the UK - there are six thresholds compared to three. And the top rate is already the highest of the four nations.

Scotland income tax rates and bands 2024-25

England, Northern Ireland, Wales income tax rates and bands 2024-25

It’s important to note that anyone earning below £75,000 a year will be marginally better off under Scotland's proposed regime.

That said, once you factor in the corrosive effects of inflation, even though the UK consumer prices index (CPI) fell below 4% in November, real incomes will fall across the board next year.

How much could tax bills rise?

If you live in Scotland, and your salary or self-employed profits exceed the £75,000 tipping point, your tax bill could skyrocket from April.

In the current tax year, earnings between £43,663 and £125,140 are taxed at 42%.

Under the proposed rates, a Scottish worker earning £130,000 a year pays an extra £1,920 a year in income tax from April and £5,378 more than workers in the rest of the UK.

But the headline tax rates don’t tell the full story. For every £2 you earn above £100,000, your personal allowance reduces by £1, meaning that this allowance disappears once earnings hit £125,140.

• Can these four ‘rules of thumb’ help you reach your retirement goals?
• My saving and investing goals for 2024

The combination of 45% income tax and a lost personal allowance creates an eye-watering effective rate of 67.5%, rising from 65% this tax year.

Once you add national insurance (NI) into the mix, the rate creeps up to 69.5%. Put simply, you only keep 30p in every pound you earn on this portion of your income.

The situation for higher earners in England and Wales is less painful, but not much. Workers pay 40% instead of 45% on earnings within this bracket, but also see their personal allowance taper away once income surpasses £100,000. This is often described as the “60% tax trap”.

Paying heavy tax and losing your personal allowance can, understandably, be a bitter pill to swallow. The more tax you pay, the less you have to spend on essentials and luxuries, plus you have reduced scope to save and invest for your future.

How can pensions help swerve 70% tax?

No matter where you live in the UK, paying into a pension can be a powerful tool to reduce your tax bill. And to benefit from the tax advantages, you don’t have to wait until April.

Let’s look at an example of this action and illustrate how pensions can beat the 70% tax trap.

For the sake of simplicity, let’s imagine you earn £125,140 in the current tax year.

If you were to pay £20,112 into your interactive investor self-invested personal pension (SIPP), we claim back 20% tax relief from the government, immediately boosting your contribution to £25,140.

Because pension payments are tax reducers, your “adjusted income” for the year will fall to £100,000 (£125,140 minus £25,140).

The upshot here is that not only will you receive 40% tax relief, but you get to keep your personal allowance too.

• Seven pension tips I learned as a financial adviser
• DIY Investor Diary: why this is the only fund in my SIPP

Therefore, a Scottish worker who makes a £20,112 net pension contribution to a SIPP before April 2024 can save £15,587 in income tax (£10,559 relief at 42% plus £5,028 for retaining your personal allowance).

And from April 2024, the saving will jump to £16,341 (£11,313 relief at 45% plus £5,028 for retaining your personal allowance).

If you live in other parts of the UK, the tax saving will be £15,084 (£10,056 relief at 40% plus £5,028 for retaining your personal allowance).

What’s more, if you were to arrange this under salary sacrifice - where you trade part of your salary for a pension payment – the tax savings could be even greater.

Once again based on earnings of £125,140, if your employer agrees to pay £25,140 into your pension and drop your salary to £100,000, you save on national insurance as well as income tax, putting an extra 2% in your pocket – or £503.

As this calculation can be complex, it can be worth seeking expert advice from a regulated financial adviser before making any decisions.

The added perk of a savings boost…

There’s a further benefit we must not overlook; your retirement savings will receive a much-needed boost.

The government may have decided to keep the triple lock for another year, which will uprate the full state pension to more than £11,500 a year from April, but it’s not nearly enough to rely on in later life.

Getting the full state pension does, of course, provide a solid foundation to build from. But it’s the personal savings that you accrue that will enable you to live the retirement that you want.

According to a recent report by the Pensions and Lifetime Savings Association (PLSA), a couple needs at least £55,000 a year to live comfortably in retirement, while the figure is £37,000 a year for a single person. Assuming you receive the full state pension, to generate this income you would need to save a combined pot of around £600,000, based on current annuity rates.

• Self-employed? Here’s the best way to save for your retirement
• 8 things you must know about building a retirement portfolio
• If you have two minutes…10 pension ‘quickies’

These figures underscore why it’s important to engage with your retirement savings as soon as possible. Due to the tax breaks on offer, pensions offer one of the quickest and easiest ways to get you where you need to be.

Recent changes to the pension system mean you now have more scope to save and invest for later life.

After the government’s decision to abolish the lifetime allowance, the amount you can build up in a pension and not get hit with hefty tax charges, you can now save and invest for retirement without a ceiling. Furthermore, the maximum you can pay into a pension every year and get tax relief recently jumped from £40,000 to £60,000.

In conclusion, if you’re worried about how the income tax system is affecting your take-home pay, and you feel your retirement savings are a bit light, then beefing up your pension contributions could provide a fitting solution.