Stealth taxes and the growing case for pension planning

Pensions have long been a formidable weapon in our tax-planning arsenal. They offer a boost on contributions at our top marginal tax rate, the money inside the account grows tax free, and up to 25% of the amount withdrawn is shielded from HMRC.

Some of the tax advantages may have been watered down over the years, but pensions are playing an increasingly important role to combat an ongoing tax grab.

• Invest with ii: Open an ISA | Top ISA Funds | Transfer an ISA to ii

What I’m referring to is fiscal drag, the revenue-raising tactic of freezing tax thresholds so that rising wages and inflation pulls more individuals into the tax net or into higher brackets.

Not increasing tax thresholds and allowances is far from a recent phenomenon, examples in the current regime can be traced back to the early 80s, but recent developments have placed it firmly under the spotlight.

In 2021-22, then-Chancellor Rishi Sunak announced that income tax and national insurance (NI) thresholds would be maintained until April 2026. In their election manifestos, both the Conservatives and Labour pledged to extend the deep freeze for two more years. The latter, in its Autumn Budget 2025, announced that it will be prolonged until 2031.

We’re led to believe tax bands will begin to creep up again at this point, but governments have previously changed tack here. Chancellor Rachel Reeves at her first Budget in 2024, pledged to end fiscal drag in four years’ time. Some 13 months later, she added a three-year extension.

Given that it captures most of the population, maintaining income tax and NI bands is a lucrative move, and so far has carried lighter political backlash compared to more obvious tax rises.

According to an explainer in the House of Commons library, the stealth tax raid is expected to generate a massive £55 billion a year by 2030-31. That’s seven times more than current annual receipts for inheritance tax (IHT).

The burgeoning media coverage of this trend and its punishing impact on our money means that awareness is growing. After receiving yearly pay bumps, people should feel better off, but they don’t. By contrast, many are feeling worse off. While some of this can be attributed to higher outgoings caused by the cost-of-living crisis, the tax squeeze is playing an equal role.

Two million caught in painful tax trap

Few examples of fiscal drag have gained more attention than the nasty snare that awaits once earnings enter six figures.

The 60% or 62% tax trap, as it’s commonly known, was introduced in April 2010. This punitive scenario is created by the combination of 40% income tax and gradual withdrawal of the £12,570 personal allowance on income between £100,000 and £125,140.

If the £100,000 threshold had kept pace with inflation over the past 16 years, it would now stand at £156,000. A freedom of information (FOI) request by insurer NFU Mutual to HMRC found that more than two million people in 2026-27 are expected to get caught by the 60% tax trap – a staggering figure.

Around 800,000 people will land in the trap, according to estimates, while the remaining 1.2 million people will earn more than £125,140, forgoing every penny of their tax-free personal allowance.

• Want to pay less tax? Here are five allowances to use by 5 April
• 8 ways to cut your IHT bill in 2026

What’s more, some of those affected will be the parents of young children, set to lose thousands of pounds in free childcare due to the brutal cliff edge in place once income hits six figures. Earn £99,999 before tax and you keep the benefit, pocket a pound more and you lose it, creating a bizarre situation where someone on, say, £130,000, could be worse off than another earning £30,000 less.

While we must recognise that no one earning £100,000 a year is scraping by, it’s hard to argue that this is fair and it may disincentivise people from racing up the career ladder.

The universal effect of fiscal drag means evidence of more people succumbing to higher taxes can be found along all rungs of the UK tax framework.

One in five people, seven million in total, are expected to pay 40% tax on some of their income in 2025-26, up from 4.4 million in 2021-22; the number of families facing the High-Income Child Benefit Charge, applied on income between £60,000 and £80,000, is expected to rise from 324,000 in 2025-26 to 359,000 in 2028-29, according to an FOI request by Quilter; and at the lower end of the system, an additional 5.2 million people will be brought into the tax net.

How pensions can help individuals, families and businesses

With each year that tax thresholds stay frozen, pulling more people into higher tax rates, the value of pension planning increases.

The thing that separates pensions from many other savings and investing vehicles is the upfront relief on offer, which crucially is applied at your marginal rate. So, if you’re 20% taxpayer, a £100 pension payment costs £80, and if you’re in the 40% bracket, it costs £60. Simply put, the higher the tax rate you pay, the more you benefit, working best when you drop down a tax bracket on retirement.

But there’s a bit more to it than that, especially when it comes to beating the 60% tax trap and child benefit charges. That’s because a pension can reduce your net-adjusted, in other words taxable, income.

For instance, say your earnings for this year are £110,000. The 62% marginal tax rate will apply on £10,000 income, meaning you only take home £3,800 from this portion. But by channelling £10,000 into a pension by 5 April – which, if you made a personal contribution to something like a self-invested personal pension (SIPP) would cost you £8,000 as basic-rate relief is added immediately – you can reduce your income down to £100,000 thus saving 40% income tax and keeping your personal allowance. A 60% equivalent tax saving. Just make sure you include the contribution on your tax return.

If you’re employed and your workplace offers salary sacrifice, where you swap a portion of earnings for an equivalent pension payment, you can save 2% NI too (note a £2,000 cap on salary sacrifice will apply from April 2029).

• What you need to know about upcoming salary sacrifice changes
• Worried about IHT? How funding your family’s pensions could help

In addition, if you’ve got young kids, using pensions to drive your income below six figures can enable your household to retain valuable free childcare payments and help to you mitigate or swerve the child benefit charge.

The attractions of pensions as a tax-planning tool extend to small business owners, who may also be feeling the pinch of fiscal drag. The threshold for the small profits corporation tax rate of 19% has remained at £50,000 since 2023 and there are no signs of an uptick.

If profits rise above £50,000, a marginal rate is applied up to £250,000, with 25% corporation tax charged above this. 

As well as helping to reduce an individual’s income bill, pensions can also lower corporation tax. Contributions made via your company are deemed an allowable business expense, offsetting the sum against its tax bill. If you planned to draw those profits as salary, it would escape NI too. We should note that not all private limited companies are vast structures with lots of staff.  Many freelancers choose to structure their affairs as incorporated businesses for the benefits they offer.

Be mindful of access rules

Before you start piling money into pensions to avert a big tax bill, there are some things to weigh up first. Any decision to invest whether the cash goes into a pension or something else, must take into account your broader financial needs and personal circumstances.

One notable feature of pensions is that under current rules you can’t access your savings until age 55, rising to 57 in 2028.

So, it’s essential to only commit money you’re able to lose access to until then. In some cases, it might be better to accept the post-tax figure, even if HMRC’s take makes your eyes water, and afford yourself more flexibility over how the cash is used.

If you’re stumped about what route to follow, taking expert financial advice could be a wise move.

Make it count by 5 April

Due to other reforms, the role of pension planning from a tax perspective is shifting. Unless we see yet another dramatic government U-turn, unspent pensions will be subject to IHT on death from April 2027. Before this controversial change was unveiled at the Autumn Budget 2024, pensions were viewed as a handy estate planning tool, especially during the 19-month window between the announcement to scrap the lifetime allowance (the limit of what your pension could be worth before being hit with heavy tax penalties) and proposal to end pensions’ IHT exemption.

• Self-employed pensions: how I’m using a SIPP for my retirement
• Is it possible to give away my pension savings to avoid IHT?

The situation with income tax, however, is a different story.

Whether you’re staring down a 62% tax bill on some of your hard-earned income, set to lose valuable free childcare, facing a charge on child benefit payments or entering higher-rate tax territory for the first time, paying into a pension by 5 April could be the smartest money move you make this year and something your future self may thank you for.