Interactive Investor

Watch out for fiscal drag: how to not pay higher-rate tax

10th November 2021 11:41

Katie Binns from interactive investor


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Chancellor Rishi Sunak didn’t touch income tax rates in the Budget – yet 1.3 million workers will be dragged over the 40% higher-rate threshold. Heres how to avoid paying it.

In April 2022, the personal tax allowance – the point at which you start paying 20% tax – will be frozen at £12,570, while the threshold for paying higher-rate tax (40%) will stay at £50,270. And neither will be increased again before April 2026.

This freeze means 1.3 million workers will be dragged into paying the 40% higher rate of tax within five years, according to the Institute for Fiscal Studies, because of the ‘fiscal drag effect’.

Whats fiscal drag?

Most of us see our wages go up each year so that they keep up with inflation – wage growth is currently 7.4%, according to the Office for National Statistics. But unless tax bands increase at the same time, workers could find themselves in a higher tax band than before, even though they have not had a proper pay rise that leaves them better off in real terms. This is known as fiscal drag.

Depending on wage growth over the next five years, people are likely to end up paying more income tax. It could stealthily creep up on you in the coming years if you dont take some action. Now is the time for your pension scheme to step up. 

By paying a little bit more into your pension, you can avoid paying 40% tax - although this will leave you with less spending money each month. We do the maths on a couple of scenarios.

Contribute more to your pension

Any contributions you make to your workplace pension are deducted from your salary before you are taxed. This reduces your taxable salary.

If you earn £50,000, dont assume a lack of promotion or pay rise will protect you from tipping the £50,270 threshold. If theres 5% wage growth in each of the next two years, you will then be on £55,125, of which £4,855 will be subject to higher-rate tax.

To mitigate that tax, you can make use of so-called salary sacrifice. You make a gross pension contribution of £4,855 and get 40% tax relief on that sum. It effectively only costs you £2,913 of your take-home pay (£4,855 after 40% tax), assuming you have no other income or tax reliefs. 

If you earn slightly less, say £45,000, and see 5% wage growth for the next three years, you will then be on £52,093. This means £1,823 of that will be subject to higher-rate tax.

To sidestep it, you could add £1,823 to your total gross pension contribution; again, you avoid paying 40% tax on the extra earnings above the threshold. This would require you to give up £1,093.80 of your take-home pay (again assuming you have no other income or tax reliefs). 

Becky OConnor, head of pensions and savings at interactive investor, says: You will still pocket the income, albeit in deferred pension form, as well as benefiting from employer contributions and tax relief, but without having to pay higher-rate income tax. If your salary rises each year, you have the option of continuing to up your pension contributions to keep your tax bill down.” 

If you have a workplace pension, then you normally need to contact the HR department to increase your monthly contributions. 

If youve got a SIPP (Self-Invested Personal Pension), then you should instruct your SIPP provider to increase your monthly contributions - or you can make ad-hoc lump sum top-ups using a debit card.

Bear in mind that salary sacrifice reduces your official earnings, which can affect other things, such as how much a mortgage lender might offer you if you are applying for a home loan. So factor this in if you also need your salary to be quoted for any other applications.

Use your ISA allowance

Any interest you receive in normal savings or investment accounts is taxable. So if you earn £50,000 a year and received £300 in interest before tax you would automatically become a higher-rate taxpayer.

You can avoid this by using your ISA allowance for savings. The income from accounts or investments held in an ISA is tax-free and does not need to be declared on tax self-assessment forms.

Expenses revisited

Justin Modray, an independent financial adviser, suggests scrutinising expenses whatever your employment status. If youre self-employed, ensure youre claiming for all those allowed by HMRC as a result of your work.

“Employees can also potentially offset expenses against income if they are incurred solely for their work and not reimbursed by their employer.”

Give money to charity

As a higher-rate taxpayer, both you and the charity benefit from gift aid donations. For every £100 you give, the charity receives £25 to boost the donation to £125 and you can claim back 20% of the £125, so £25, against your tax bill.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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