Welcome to the Money Agony Aunt series where we address some of the most commonly asked money questions.
Question: What happens when my income is between £100k and £125k?
Answer: You have entered the dreaded 60% income tax trap.
As you are a higher-rate taxpayer, you may firstly expect to be paying the usual 40% income tax. Unfortunately, when your income enters this range, this might not be the total deduction. Below we explore how it works.
To understand where the 60% tax rate comes from, let’s start with how income is taxed in the UK.
| Income | Tax rate | Name |
| £0 – £12,570 | 0% | Personal allowance |
| £12,571 – £50,270 | 20% | Basic rate |
| £50,271 – £125,140 | 40% | Higher rate |
| Over £125,141 | 45% | Additional rate |
Ok so 60% is not in the above table. That’s because it is not an official tax band recognised by HMRC. Instead, it is a calculation of how much tax you end up paying when your Personal Allowance is reduced.
The Personal Allowance is the first slice of income (£0 to £12,570) that is taxed at 0%. As your income starts exceeding £100,000, you start to lose your Personal Allowance.
For every £2 you earn over £100,000, you lose £1 of your Personal Allowance. When your income is £125,140, your Personal Allowance is completely gone.
It is easier to illustrate with an example.
- Julia earns £100,000 and gets a £10,000 pay rise.
- The £10,000 gets taxed at 40%, her normal higher rate. So she pays £4,000 of tax.
- But for every £2 she earns over £100,000, Julia loses £1 of her tax-free Personal Allowance.
- At this 2:1 rate, Julia will lose £5,000 of her Personal Allowance.
- This also needs to be taxed at her 40% higher rate.
- 40% of £5,000 is £2,000 of extra tax.
- So on the £10,000 pay rise, Julia is taxed £6,000 in total (£4,000 + £2,000).
- £6,000 is 60% of the £10,000 pay rise.
That’s how the sneaky 60% tax rate happens.
Also, a quick note on what we mean by “income” here. It is technically “adjusted net income” which includes salary. But it can also include other types of income; most commonly, rental income and interest on savings (in excess of associated allowances). Something to bear in mind because these other types of income might tip you over the £100k threshold even if your salary is under £100k.
Adjusted net income deducts two things – a clue as to what you can do if you are in the 60% tax trap:
- Pension contributions
- Charity donations via Gift Aid
If you are in the 60% tax range, what can you do?
- Make a pension contribution
You can make a gross pension contribution. This can reduce your adjusted net income. In Julia’s example, she could make a gross pension contribution of £10,000 and this would take her adjusted net income down to £100k.
A quick note on “gross”. In the pension contribution world, it means the pension contribution plus basic-rate tax relief of 20%. So in Julia’s example, she could contribute £8,000 of her own money. The contribution would then be “grossed up” by £2,000 to make a gross pension contribution of £10,000.
How does this impact her tax situation?
- First, Julia receives 20% basic-tax relief on her pension contribution (the £2,000 mentioned above).
- Second, Julia is a higher-rate taxpayer. This means that she could claim a further 20% tax relief on her pension contribution by completing a tax return. This is a further £2,000.
- Third, by taking her adjusted net income back to £100k, Julia reclaims the Personal Allowance that she lost. That £5,000 of her Personal Allowance that was taxed at 40% (i.e. £2,000 of extra tax) is no longer taxed.
So the 60% that Julia lost in tax – she could get it back.
- Make a charity donation via Gift Aid
A charity donation made via Gift Aid can reduce adjusted net income. Once again, it is the “gross” donation that is deducted from the adjusted net income. A “gross” donation is the initial donation plus Gift Aid on top.
Let’s go back to Julia to illustrate this point.
- Julia can make a donation of £8,000 via Gift Aid to a charity.
- The charity then claims Gift Aid of 20% on Julia’s donation.
- This is £2,000 on top of Julia’s £8,000 donation.
- It brings Julia’s gross donation to £10,000 (£8,000 + £2,000).
- When Julia completes her tax return, she would need to include her gross donation of £10,000.
- Her net adjusted income would be reduced by her gross donation via Gift Aid. So it would reduce from £110,000 to £100,000.
It is a common mistake to include only the net amount (in Julia’s case £8,000) on the tax return. It should be the gross amount; the initial donation plus Gift Aid (in Julia’s case £10,000).
How does this impact Julia’s tax situation?
- As a higher-rate taxpayer, Julia can claim back 20% of her gross donation i.e. £2,000.
- By taking her adjusted net income back to £100k, Julia reclaims the Personal Allowance that she lost. That £5,000 of her Personal Allowance that was taxed at 40% (i.e. £2,000 of extra tax) is no longer taxed.
If you would like to discuss your situation or need help understanding your options, then please don’t hesitate to get in touch.
Risk warning: With investing, your capital is at risk. Tax treatment depends on an investor’s individual circumstances and may be subject to change. Opinions constitute our judgement as of this date and are subject to change without warning. Past performance is not a reliable indicator of future results. This article is intended for informational purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.