Our income tax bills are rising: the lowdown on fiscal drag

Income tax rates might not have been increased in this year’s Autumn Budget – which had looked pretty likely for a while – but that’s not to say our income tax bills aren’t going to sneak up over the coming years.

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That’s because the government chose to extend the existing freeze on income tax and national insurance (NI) thresholds from 2028 by a further three years, to 2031 (at the earliest).

This means that the tax-free personal allowance will remain frozen at £12,570, the threshold for higher-rate tax will be stuck at £50,270 and additional rate tax will continue to kick in once earnings exceed £125,140.

Until recent years, income tax thresholds have always increased annually, in line with inflation.

However, that link ground to an abrupt halt in 2021 when then Chancellor Rishi Sunak announced that income tax thresholds would be frozen from 2022 to 2026. The Conservative government then extended it again until 2028, before Labour announced the latest extension to 2031 in this year’s Autumn Budget.

What do frozen thresholds mean?

The result – coined “fiscal drag” - is that as our incomes rise, more low-income households start paying tax, while more workers and retirees are dragged into paying tax at higher rates.

Under the old, inflation-linked system, you would normally only get bumped up a tax bracket if you’d enjoyed a notable increase to your income. Now you can get caught out through gradual increases to wages and without seeing any material difference to your disposable income.

To put the issue into perspective, in 2010 only one in 10 taxpayers paid higher-rate tax. Now, it’s not far off one in five (18.1%). And, by 2030, it’s thought that almost a quarter of people will pay higher or additional rate tax.

The number of pensioners, meanwhile, who pay tax, has already increased by around a third to 8.8 million over the last four years as a result of frozen thresholds. And, more than one million pay the higher or additional rate of tax – a figure that’s doubled over the same period.

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By 2030, consultancy LCP now estimates that around 10 million pensioners (three-quarters of the total) will pay income tax, up from 6.5 million in 2020.

Counting the cost of fiscal drag

Freezing tax thresholds is a stealthy, but effective way to raise tax revenues. The latest three-year extension is expected to raise £23 billion, taking the total gain over the decade to £55.5 billion.

According to the Office for Budget Responsibility (OBR), the personal allowance would have reached £17,490 (a further £4,920) by 2030-31 had the inflation link remained, while the higher-rate threshold would stand at £70,390 (a further £20,120).

But fiscal drag doesn’t just mean bigger income tax bills. It’s actually even stealthier than that.

If you’re dragged into the higher-rate tax bracket – even if just by a £1 – it could also expose your savings and investments to higher rates of tax.

Basic-rate taxpayers, for example, can enjoy £1,000 of savings interest tax free with the personal savings allowance. But once you start paying higher-rate tax, that allowance is halved to just £500. And if you trip into the additional tax rate, which kicks in on income above £125,140, you don’t get a savings allowance.

The rate of capital gains tax also jumps from 18% to 24% when you become a higher-rate taxpayer.

Could you beat fiscal drag?

The policy to freeze tax thresholds paints a pretty bleak picture and will take a shine off any increases to your income over the next five and a bit years.

It could be particularly punitive for retirees who need to increase their pension income to keep pace with rising costs.

But, depending on your situation, there may well be steps you can take to safeguard more of your income and wealth from tax, with a stealthy bit of planning of your own.

• Pay more into your pension

Topping up your pension is one of the canniest investments you can make. First, you’ll be putting more money aside for your retirement, but second you’ll be reducing your income for tax purposes. This might not just reduce your income tax bill – if you’re on the cusp of paying higher or additional rate tax, you can also use your contribution to bring your taxable income below the relevant threshold, preventing you from paying tax at the increased rate.

Higher earners can also use this trick to stave off the 60% tax trap (which occurs on earnings between £100,000 and £125,150, when the personal allowance is gradually tapered away). Similarly, working parents who are affected by the high-income child benefit charge, which is applied on income between £60,000 and £80,000, may be able to keep all or more of their child benefit by increasing their pension contributions.

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Most people can pay 100% of their earnings into a pension each year, up to a maximum of £60,000. You might have a lower allowance if you’ve already made a taxable withdrawal from your pension (in which case you will have trigged the £10,000 money purchase annual allowance) or if you have an adjusted income over £260,000 (at which point your allowance starts to be tapered away).

• Stick with salary sacrifice

Salary sacrifice is the most tax-effective way to pay into a workplace pension, if your employer offers it. This is because you get (NI) savings on top of income tax benefits.

But while the chancellor did confirm that the NI benefits would be limited to contributions up to £2,000 a year, this new rule won’t come into force until April 2029.

That means if you’re currently using salary sacrifice, you’ve still got more than three years to make the most of it.

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That could be by increasing your regular pension contributions or using it to pay any bonuses you might receive into your pot. So-called “bonus sacrifice” means you get the full value of your bonus paid into your pension – without losing any to tax or NI.

• Get your savings and investments wrapped up in an ISA

With tax on dividends set to increase by 2 percentage points from April 2026, and savings interest to hike by the amount the following year, it’s even more important to ensure any savings and investments outside your pension are sheltered from tax.

You can do this by using a cash or stocks & shares individual savings account (ISA).

Each year, you can pay up to £20,000 into ISAs and there will be no tax to pay as your money grows, or when you make withdrawals. The chancellor did announce that the cash allowance for under 65s would be reduced to £12,000 in the recent Budget, but this will only come into force from April 2027.

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If you’ve got investments in trading or general investment accounts, you can also transfer them into a stocks & shares ISA using the Bed & ISA process, so long as you have enough allowance remaining for the year. This will shelter your investments from tax in the future, you just need to avoid crystallising gains worth more £3,000 a year, to ensure there’s no capital gains tax (CGT) to pay on the sale.

• Use ISAs in retirement

ISAs don’t benefit from the upfront tax perks of pensions but the fact that all withdrawals are tax free means they have a pivotal role to play in retirement.

For example, retirees who need to limit withdrawals from drawdown plans to avoid paying higher-rate tax, can top up their income tax-free by taking money out of ISAs as well.

So, while you might normally prioritise your pension for later life and use your ISAs for shorter-term goals, it’s worth thinking about how you can use the two together to pay less tax in retirement.