Interactive Investor

Three income tax traps that are a drag on building wealth

20th July 2022 10:50

Rachel Lacey from interactive investor

The fiddly UK tax rules mean that there are tax traps when you reach certain income thresholds. Rachel Lacey helps you navigate your way through them.

At first glance, the taxation of our income looks pretty straightforward. Tax is applied as a fixed rate of your income and so the more you earn, the more you pay.

However, the UK tax system is a tricky beast and not without its quirks. As your earnings grow, there are a number of thresholds and allowances that change, creating ‘tax traps’ or ‘sinkholes’ where you’ll see your income tax bill go up.

You may not always be able to totally fend off these tax increases. Nonetheless, in the short term, some tactical tax planning could help you stave off these spikes and make it easier to continue building your investment wealth.

We’ve pinpointed three earnings milestones it could pay to be aware of.

£50,000

If you have children and claim child benefit, you may become subject to the ‘high income child benefit tax charge’ once you or your partner’s income exceeds £50,000. This is charged at a rate of 1% of the child benefit you receive, for every £100 of income you earn between £50,000 and £60,000.

Once you earn £60,000, the charge will be equivalent to the amount of child benefit you receive.

At this point, you can either cancel your child benefit or pay the tax charge through a self-assessment tax return.

£50,270

This is the current threshold for the higher rate of tax. This means that anything you earn over £50,270 will be taxed at the rate of 40%, rather than the 20% you’ve been paying so far.

It is perhaps a push to call this natural progression a tax trap, but it is worth a mention as you could still potentially stave off the tax increase for a period with clever tax planning.

£100,000

This is the big one. Once your earnings hit £100,000, you could start paying an effective income tax rate of 60%.

This is because the £12,570 personal allowance – the amount you can earn before you start paying tax – starts to gradually be removed once your income exceeds £100,000 a year.

The personal allowance is currently tapered away at a rate of £1 for every £2 that you make over £100,000 and, by the time your earnings reach £125,140, you no longer get any benefit from it.

As a result, for every £100 earned between £100,000 and £125,140, you’ll pay £40 in income tax and £20 will be lost from the personal allowance. That creates an ‘unofficial’ tax rate of 60% and leaves you with just £40 of the £100 you earned.

Beat the tax traps

Paying more tax is an inevitable part of earnings growth and you wouldn’t want to not see your income rise. Nonetheless, these tax traps can still be frustrating when you’ve just crossed the threshold.

In some cases, you may well be able to avoid a tax spike when your salary rises by diverting that income elsewhere.

The ‘trick’ is to reduce your taxable income – so that it falls below the relevant threshold – without harming you financially.

Use your pension

The easiest and most obvious way to do this is to pay more into your pension. This can be a very savvy move.

In addition to reducing your taxable income (and potentially reclaiming your personal allowance if you’re a higher earner) you also get the added boost of tax relief on your pension contributions.

One option is to increase contributions to your workplace pension.

Alternatively, you could pay more money into a personal pension such as a SIPP. For tax purposes, HMRC would consider your ‘adjusted income’, which is your total income, minus payments into your pension.

It’s important, however, to ensure that higher-rate taxpayers who pay into a SIPP, complete a self-assessment tax return to get the full amount of tax relief they are entitled to. Only basic-rate relief is applied automatically.

For workplace schemes, you will need to clarify whether it’s a net pay arrangement, where pension contributions are made before your income is taxed, or a relief at source arrangement. If it’s the latter, you’ll also need to claim higher tax relief back through a tax return.

You’ll get the full benefit of tax relief straightaway with a net pay scheme.

There aren’t many arguments against increasing your pension contributions – your older self will certainly thank you for it. However, if that doesn’t work for you, you could discuss taking non-cash benefits with your employer. This could include using salary sacrifice arrangements to reduce your taxable income and pay for anything from childcare to gym membership or extra holiday.

Whichever route you are considering, tax planning can be complicated, particularly if you are earning north of £100,000. That means that it’s likely to be worth getting some professional advice before you make any major decisions.

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