Tax traps to be aware of and how to beat them

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Frozen thresholds mean more people are being caught by an effective 60% tax rate. To discuss this topic, including providing practical pointers on how to beat this tax trap and the child benefit tax trap, Kyle is joined by Craig Rickman, personal finance editor at interactive investor. 

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly show that aims to help you make the most out of your savings and investments.

In this episode, we are going to be discussing some of the biggest traps that are lurking in the UK tax system. Joining me to discuss this topic is Craig Rickman, personal finance editor at interactive investor. Craig, welcome back to the podcast.

Craig Rickman, personal finance editor at interactive investor: Thank you very much for having me on.

Kyle Caldwell: Before we go into the topic, a little ice-breaker, pub quiz question for you. What is 22,000 pages long? I’ll give you a clue: it is related to the episode.

Craig Rickman: All right, I don’t know. The UK tax handbook?

Kyle Caldwell: Yeah. I mean, essentially, it is. It’s how long the UK tax code is, which is the longest tax code in the world. And as we’re going to be talking about, it is very complicated. This is the reason why some people can fall into potential tax traps.

Craig Rickman: Right, OK. That’s interesting. I didn’t know that. I feel like I should, but I didn’t.

Kyle Caldwell: Before we go into the tax traps, could you define what a tax trap actually is?

Craig Rickman: Sure, yeah. Tax traps are a huge topic at the moment. But to break down what a tax trap means, essentially, there are quirks in the UK tax system where you can pay an unusually high effective rate of tax.

The UK tax system is constructed on what’s called a progressive basis, meaning that as your earnings or your income rises, then the tax rates rise with them. So, if we look at the income tax system in England, Wales, and Northern Ireland, you pay no income tax on the first around £12,500. Between £12 500 up to around £50,000, you pay 20%. Forty per cent just above £50,000 up to just around the £125,000 mark, and then 45% on anything above, so they increase as your income increases.

However, lurking within the framework due to things like lost valuable allowances and potential charges for benefits that you might receive, the combination of that and the marginal rates you pay, can create tax rates or effective tax rates of 50%, 60%, or perhaps even more on a portion of your income.

In some cases, due to some of these tax traps, you could even be worse off. What we’re seeing over time is that more people are falling into these traps, and a big reason for that is something called fiscal drag, which has been making a lot of headlines in the past few years. It is this economic phenomenon of frozen tax thresholds or tax thresholds being frozen over time, and as people’s incomes rise, then more of them are tripping into higher rates of tax and tripping into these tax traps.

Kyle Caldwell: Let’s unpack fiscal drag, which, as you mentioned, is the main reason more people are being pulled into tax traps. So, we’ve had frozen personal tax thresholds since April 2021, and they’re going to stay frozen until 2031. The personal allowance has been frozen at £12,570 a year, and the higher-rate threshold has been frozen at just over £50,270.

In my view, fiscal drag is a very sneaky way to increase the tax burden over time. It results in people paying tax more on their income as their income rises in line with wages going up. And it’s much less obvious than raising tax rates, and it makes wage increases become less meaningful.

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Craig Rickman: Well, absolutely that. And with relevance to the tax traps, it means people can be pulled into them unwittingly. So, as you know, when salaries rise, naturally rise over time in line with inflation, where people receive bonuses, or they receive income from other sources, if the tax thresholds are frozen, then without them really knowing about it, they can get pulled into these really punishing tax rates.

So, yes, the impact of fiscal drag, as you say, many of the tax thresholds have been frozen since the start of the decade, but there are other instances within the tax framework of fiscal drag being around for a lot longer as well. It’s become a bit of a feature of the tax system and it can be quite punishing for a lot of people.

Kyle Caldwell: One tax trap that’s been getting a lot of attention, particularly at the moment, is the one that kicks in when earnings exceeds £100,000. This is dubbed either the 60% or 62% tax trap.

You think that, actually, this is not going to impact that many people, but it does. It’s going to impact around two million people in the current tax year. Now, those earning over £100K are in the top 5% of earners.

However, the amount of tax being paid is punitive, and the £100,000 figure hasn’t increased since the system was introduced in 2010.

Craig, could you explain why, due to the way the tax system works, people in that bracket are being hit with a 60% tax trap?

Craig Rickman:Sure, yeah. So, once your earnings go above £100,000, for every £2 that your income exceeds £100,000, you lose £1 of your £12,570 personal allowance. So, once your income reaches £125,140, you lose your tax-free allowance. The combination of that, plus the 40% income tax you pay, creates this 60% tax trap.

Once you factor in national insurance as well, which is paid at 2% on earnings above £50,270, it’s a 62% tax trap. So, yeah, what that means is on that proportion of income, the government would take 62p in every £1 that you earn. So, punitive stuff.

Going back to your point around fiscal drag and the two million people who are expected to earn above £100,000 this year, if we go back to when that system was introduced in 2010, the number was just under 600,000 - it was 588,000. So, in the 16-year period, you’ve seen four times as many people fall into this pretty nasty tax trap.

As you know, tax thresholds are due to remain frozen until 2031, so even more people are going to pay a really punishing rate of tax.

Kyle Caldwell: And it’s your taxable earnings, so that includes if you get a bonus, it’s not just your base salary?

Craig Rickman: That’s right. It’s called adjusted net income or taxable income. But, yeah, it’s your total income. That could be from salary, it could be from bonuses, it could be from interest that you receive in any savings accounts that exceeds your savings allowance. If you’re a higher-rate taxpayer, you get a savings allowance of £500 a year, so anything that exceeds that will go towards it.

It could be dividends that you receive from shareholdings outside tax wrappers. It could be property income. That’s one of the ways that people can get caught out because you may assume that it’s just your salary and your bonus that gets impacted by this tax trap.

But it’s essentially any form of taxable income that you have. For the earnings in that portion, the government is taking a bigger share of your income than you get. So, it can be a bit of a deterrent, but still at the same time, if someone’s earning £99,000, they’ll still have less money at the end of the month than someone who earns, say, £110,000, unless they are parents of young children. So, that’s one of the particularly punishing areas of the tax system.

Kyle Caldwell: This is because if you earn £1 over a £100,000, then you lose out on potentially on thousands of pounds in free childcare, and this particularly impacts those who have young children.

Craig Rickman: Yeah. This is without a doubt, the most punishing tax trap or punishing aspect of the tax system. The main reason for that is it’s applied at a cliff edge rather than a tapering system, like applies to the 60% tax trap.

So, once earnings reach or exceed £100,000 a year, you can lose free childcare. So, you can lose tax-free childcare. I mean, it’s called tax-free childcare but that’s a little bit misleading, or very misleading. It works as more of a top-up to childcare, so that for every £1 you pay, the government could potentially pay up to 20p. That’s worth £2,000 a year, so you would lose that if earnings exceed £100,000, plus you can lose free childcare hours. So, parents of young children, and the ages of these children, or the ages where this childcare applies, are those between nine months and four years. Up to five essentially.

But those [people] could also get 30 hours of free childcare, but that reduces down to 15 hours if you earn £1 above £100,000. So, yeah, the situation is that families could be thousands of pounds worse off by earning just £1 more.

In fact, a think tank crunched some numbers on this recently and found that someone, if you took a fairly extreme example, would have to earn £145,000 a year to not be worse off. So, you have this bizarre situation where you could have someone earning £99,000 who’d be better off than someone else earning £140,000 because of the way the childcare system works, which is astonishing. Not to mention deeply unfair.

Another aspect of the unfairness is that it only applies to a single person’s income. So essentially, you could have a household where you have two people working and they each earn £99,000 a year, they get to keep the free childcare.

You have another household where one doesn’t work, looks after the children, one spouse or partner, and the other works and earns £100,000 a year, so effectively half, and they lose the free childcare.

So, that’s another punishing aspect of it. There are lots of accusations of unfairness and they’re difficult to disagree with. It seems, frankly, quite a ridiculous system.

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Kyle Caldwell: I completely agree. It’s a grossly unfair system based on one person rather than based on the wages of the household.

On a more positive note, this is something that the education secretary has said they are looking at and the £100,000 childcare cliff edge is under review. So, hopefully, we’ll get some sensible reform in that area that no longer penalises those who are impacted by that cliff edge.

However, that’s not the only tax trap that affects parents of young children. There’s another one lurking in the system once earnings exceed £60,000, and this is called the high income child benefit charge. So, this increases the effect of marginal tax rates for parents with one, two, or three children to 49%, 53% and 58%.

Craig, could you talk us through it?

Craig Rickman: I can indeed. So, if you are a parent of children aged up to 16 or up to 20 and in full-time education, then you can claim child benefit. So, the child benefit payments are for the first child, it’s paid weekly, but you get around £1,400 a year. Then for any subsequent children, you get around £930 a year. So, for a household with two children, you can claim about £2,300 a year. So, a valuable source of household income.

However, when one person’s earnings start to exceed £60,000, then you can face a charge on child benefit. The charge is for every £200 above, the charge is 1%. So, what that means is, once income hits £80,000, the charge equals the amount of child benefit. So, it’s completely wiped out.

In a similar problem to the childcare system applied at the £100,000 cliff edge, it’s based on one partner’s income. So, it’s not a household income. So, you could have a situation where you had two people each earning just under £60,000 a year within the household, so collectively £120,000, and they can still claim the child benefit payments or, more accurately, they wouldn’t face a charge on the child benefit payments. Whereas if you had another household where one person was earning £80,000, then they pay the full charge, wiping out the child benefit payments.

So, again, it’s another punishing tax trap lurking in the system that can catch people out.

Kyle Caldwell: It can make sense for some people earning £80,000 or more to apply for child benefit and then not receive it. Could you explain why?

Craig Rickman: Yeah, sure. Because that could be the temptation, couldn’t it? You might think, well, if I’m going to pay this charge on the child benefit payments, then what’s the point in claiming it? But there’s a really good reason to claim it.

That’s because by claiming child benefit, it counts towards your state pension record. So, it’s counts as a qualifying national insurance credit, and so it enables you to build up really valuable qualifying years for your state pension.

But as you note, you can claim child benefit but opt out of the payments because the way that the child benefit charge is collected is typically through an adjustment to PAYE. So, it’s collected elsewhere through the tax system.

But if you didn’t want that to happen, then, yeah, you would say you want to claim child benefit but you’re opt out of the payments, and that means that you avoid getting into the situation where you receive child benefit and then pay a charge, but it can also count towards your state pension record.

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Kyle Caldwell: So, this would count towards your spouse’s state pension record if they’re not working, and you’re in a position where you earn £80,000 or more?

Craig Rickman: That’s right, yeah. So, it would be essentially, the caregiver. So, the one who’s looking after the children, the one who’s out of work, that’s the person to claim. Yeah, absolutely right.

Kyle Caldwell: The threshold for the high income child benefit charge, it used to be between £50,000 and £60,000. When that change was made, the previous government also proposed to make the system fairer by moving to a household income system by April of this year. However, that’s not happened. Labour scrapped those plans in its first Budget, as it thought that the change would be too expensive.

Craig Rickman: Yes. That’s a real shame that would’ve gone a long way towards making this system fairer, which, as we’ve discussed, really isn’t fair in its current form, so that’s a real shame.

I think all we can do is hope that the current government or a future government revisits the problem. Especially if they’re looking at the £100K cliff edge for free childcare, it would make sense to look at this as well and address the unfairness within this part of the system.

Kyle Caldwell: So, how can people practically try and beat this big tax trap, the £100K cliff edge? Is the first port of call looking at pensions and potentially making greater pension contributions and that’s going to reduce your taxable earnings overall?

Craig Rickman: Yeah. Pensions can be a really effective tool when planning around tax traps. That’s because, as you’ve noted, pension contributions can reduce what’s called net adjusted or taxable income.

The thing to consider there is that when you’re putting money into a pension for this purpose, you can’t get your hands on that money until age 55, and that’s rising to 57 in 2028.

So, it’s really important to bear that in mind, but provided you’re happy to lose access to the money, and for some people, they might be short on their retirement savings anyway, so it can help solve that problem.

But paying into a pension can be a really good way to avoid the trap.

So, let’s look at a basic example. Let’s say you earned £110,000 a year. If you pay £10,000 personally into your pension that year, and I say personally, it could be through your employer as well, and you can reduce your income down to below a £100,000, then you can potentially avoid the tax trap at 60% or 62%, plus keep the valuable free childcare as well.

So, in some cases, by paying into a pension, you can actually be better off. There’s a couple of ways that you can go about it. If you’re employed and your employer offers salary sacrifice, then you can just reduce your income below £100,000. So, salary sacrifice works where you trade a portion of your income for an equivalent pension payment. In that scenario, it could be instead of receiving £110,000 a year salary, you reduce it down to £100,000, hence swerving the tax trap, potentially keeping free childcare.

What we should note is that not everyone is employed and has access, and even those who are, to salary sacrifice. So, the other way you can do it is to make personal pension contributions to something like an interactive investor SIPP.

So, in that scenario, let’s say you wanted to make a contribution of £10,000, you pay £8,000. That’s topped up by £2,000 by the government with basic rate tax relief. So, then that can reduce your net adjusted income by that amount.

If you are using the latter and you’re making personal contributions, the really important thing to do is make sure you put it on your tax return. So, even though you’re making pension contributions, you need to tell the tax authorities that that’s what you’ve done.

But, yeah, pensions, as long as you’re happy to tie the money up until retirement, can be a wonderful tool to help beat the tax traps. And, particularly around the free childcare cliff edge, you could end up being better off as a result.

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Kyle Caldwell: So, as you just explained, Craig, upping your pension contributions is pretty much the main way to try and stay below that £100,000 threshold if it makes sense for you to do so. However, another way is to give away some of your money to charity through gift aid as this reduces your overall taxable income.

Craig Rickman: That’s right. So, if you’ve got any causes that you’d like to support and you’re feeling generous towards those, then, yes, making donations to a charity could also reduce your taxable income.

In the same vein as making personal pension contributions, again, that’s something you would need to place on your tax return. But, yeah, it can be an effective way to reduce your taxable income.

Kyle Caldwell: So, while that’s another way to go about trying to beat the £100K tax trap, the main one, as you’ve covered, is, if you can, increase pension contributions, whether that be into a workplace pension or into a self-invested personal pension, a SIPP.

Those who are earning between £100,000 and £125,000 and are caught out by the £100K tax trap, they can put up to £60,000 a year into a pension.

Craig Rickman: That’s right, yeah. Most people can put up to £60,000 a year or a 100% of what you earn, whichever of those is lower into a pension and get tax relief at your marginal rate.

Kyle Caldwell: Well, Craig, I think you’ve provided plenty of food for thought for those who are potentially impacted by some of the biggest traps in our UK tax system. Thanks for coming on.

Craig Rickman: Thank you very much for having me.

Kyle Caldwell: And thank you for listening to this episode of our On The Money podcast.

We love to hear from listeners, and the way to get in touch is by emailing: OTM@ii.co.uk. We love to hear from you if you have an interesting idea that you’d like us to cover on the podcast, or you have a question that you would like myself or one of the team to tackle in a future episode.

In the meantime, you can find plenty of analysis related to personal finance and investments on the interactive investor website, which is ii.co.uk, and I’ll hopefully see you again next Thursday.