The pension trick saving parents thousands in tax and free childcare

A story emerged late last week that thousands of parents are expected to swap pay rises for pension contributions to swerve a punishing cliff edge once earnings hit £100,000.

This bizarre scenario shines a very bright light on a ludicrous quirk within the UK tax regime. Simply put, if one parent of young children earns above six-figures, valuable free childcare can be lost, potentially shrinking household income by tens of thousands of pounds.

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According to the report, published by The Telegraph, 1,100 parents are smartly harnessing pension payments to keep their income below £100,000. And this number is forecast to hit 12,000 by the end of the decade with more families affected as their incomes breach the frozen threshold.

While it’s encouraging that parents are taking steps to swerve this expensive banana skin, due to complexities within the tax system, parents still risk getting caught out.

Let’s explore the tax trap and cliff edge that awaits once income hits six figures and unpack how pensions and other strategies can help.

A deep chill that’s lasted 16 years

The £100,000 tax trap, as its known, is far from a recent headache for higher-earning Brits. The policy was introduced in 2010 by then-Chancellor Alistair Darling and is one of the most enduring examples of fiscal drag – a sneaky, government tax-raising strategy that’s become a dominant theme in recent years. 

The tax trap threshold hasn’t budged since launch, with the number of people hauled into its net rising from 588,000 in 2010 to more than two million today.

According to the Bank of England’s inflation calculator, the threshold would now be around £160,000 if it had risen in line with inflation over the past 16 years.

The way that this tax trap works within the existing framework is as follows: for every £2 of income above £100,000, £1 of your £12,570 tax-free personal allowance is taken away, meaning it disappears once you earn £125,140.

The combination of withdrawn personal allowance and 40% income tax on this portion of earnings, creates a rather nasty 60% effective rate, which hikes to 62% if you pay national insurance (NI). And for anyone with outstanding student debt, the rate could rise above 70%. 

Saying goodbye to £6 or £7 in every tenner you earn is an understandably deeply bitter pill to swallow, not to mention a disincentive to further your career.

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Further pain for parents in 2017

Some seven years after taking effect, the government once again homed in on the £100,000 threshold, introducing a reform that created even harsher punishments for certain groups.

In 2017, tax-free childcare and tax-free childcare hours were introduced, available to eligible working parents of children aged from nine months up till they start school.

However, to receive the payments, specific rules needed to be satisfied: both parents must work at least 16 hours a week and have taxable earnings below £100,000. And unlike the 60% tax trap, a cliff edge was imposed instead of a taper. For those on the cusp, earning just a pound more can prove devastatingly expensive.

With tax-free childcare you can get up to £500 every three months, which jumps to £1,000 if your child has a disability, to help towards childcare costs. It’s essentially a top-up scheme, where the government will add £2 to every £8 parents’ pay with a quarterly cap.

Elsewhere, if your child is aged nine months to four years old, you can get 30 hours of free childcare per week for 38 weeks of the year. On average this is worth around £7,000 a year per child, so it’s incredibly valuable.

However, if one parent earns above £100,000, free childcare hours are restricted to 15 hours a week, and tax-free childcare disappears, blowing a gaping hole in your household finances.

In some cases, you might have to pocket £140,000 or perhaps more to avoid being worse off - an extraordinary scenario. And the unfairness doesn’t end there.

As the rule applies to one parent’s income, it’s feasible to have a situation where a household with single earner on £101,000 a year loses the payments, while another with two parents each earning £99,000 a year, keeps them.

A further point is that when the decade-long freeze on income tax and NI thresholds finally ends in 2031, there’s nothing to suggest the £100k tax trap will increase. Between 2010 and 2021, it remained fixed even though the other tax bands ticked up.

Tax hacks to help out

Whether you’re seeking to swerve the cliff edge, and/or avoid the tax trap, the key is to reduce what’s called your adjusted net income. This is the figure HMRC uses to calculate your annual tax bill and assess eligibility to benefits like free childcare.

As many parents have worked out, a handy trick to lower your taxable income is paying money into a pension. If used correctly, it’s an effective way to protect today’s finances while beefing up retirement funds.

The options for funding a pension can depend on whether you’re employed or work for yourself, and the terms of your workplace scheme if you’re the former.

1) Salary sacrifice

This is the perhaps the simplest method to reduce your adjusted net income, provided your employer offers it. With salary sacrifice, you trade a portion of your salary in exchange for an equivalent pension payment.

So, let’s say you earn £99,000 and your spouse is a basic-rate taxpayer, you have two young children and receive a pay rise of £4,000 for the coming year.

By swapping the pay rise for a pension payment, you can save 40% income tax, 2% NI, keep all your tax-free personal allowance and retain free childcare payments – a move that could be worth tens of thousands of pounds.

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And it isn’t just salary that can be traded in this manner; many employers will let you sacrifice bonuses into a pension, too. Normally you don’t have to swap the whole lot. You could, for instance, sacrifice the amount of bonus that trips you over the threshold and have the rest paid into your bank account.

2) Make personal pension payments

If you’re self-employed or your employer doesn’t offer salary sacrifice, not all is lost. Making personal pension contributions, into either your workplace scheme or something like a self-invested personal pension (SIPP), can have broadly the same effect.

There are a couple of key differences here though. First, basic-rate relief is added upfront rather than deducted before tax is calculated. So, if you want to make a £4,000 contribution, you pay £3,200 into your SIPP. You get 20% relief (£800) immediately, while the remaining relief and restoration of personal allowance is exercised via self-assessment.

Second, because the contribution is made from post-tax income, you don’t enjoy NI relief - but bear in mind that’s only 2% for anyone earning £50,270 or more.

3) Company directors

As owner/directors of private limited companies typically draw a small salary and the rest in dividends, the situation is a bit different. Importantly, dividends do count towards adjusted net income, but an upshot of being a company director is that you have more control over how and when you pay yourself.

Planning can be more complicated here, as making pension contributions via the company is usually the best option for directors, but only personal contributions reduce adjusted net income.

The right approach for you will depend on how you structure your income, so it’s worth seeking specialist tax advice from an accountant or regulated financial adviser.

Understand pension rules…

If you’re a parent caught out by the childcare cliff edge, while paying more into your pension should be a no-brainer, it’s worth understanding contribution limits and access rules. Most people can pay the lower of £60,000 or 100% of earnings into a pension every year and get tax relief, offering plenty of scope for six-figure earners.

The one drawback is that the money is locked up until age 55, rising to 57 in 2028. However, this shouldn’t be an obstacle if the pension payment will enable you to retain free childcare, making you better off today.

• Don’t get tripped up by interest and dividends

When calculating your adjusted net income, it’s vital to note that it’s not just your salary or self-employed profits that comprise calculation. Income from rental properties and benefits-in-kind must be factored in, too.

The same goes for any interest from savings and, as noted above, dividends from investments outside of tax wrappers above your annual exemptions. The first £500 of dividends are tax free, while higher-rate taxpayers get a £500 savings allowance. Overlooking these income sources could mean your pension contribution falls short of the figure required to stay below £100,000.

Some careful planning might be required here. Using your £20,000 individual savings accounts (ISA) allowance should be your first port of call - maximising between both parents where possible - as dividends and interest are tax free.

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Beyond ISAs and your savings allowance, holding investments and savings in a lower earner’s name could be a smart move. Not only can this keep you below the cliff edge, but if the other parent is in a lower tax bracket, they’ll get a more generous savings allowance and pay reduced rates on dividends and interest.

Premium bonds are another option, as any prizes – which importantly aren’t guaranteed – are tax free.

Something to flag is that capital gains don’t count towards your adjusted net income, so you can ignore these for the calculation.

• Charity donations can help too

If there are any good causes you’d like to support, making charitable donations is another way also push down your taxable income. Just ensure you make a Gift Aid declaration to get an immediate 25% tax uplift and remember to claim the rest though your tax return.