Did you know that some UK taxpayers face an effective 60% tax rate due to income thresholds and phased-out allowances?
This guide unpacks the “tax trap” lurking in the UK’s tax system, explaining how it affects higher earners and offering practical steps to manage and reduce your tax burden.
If you’re navigating the UK’s tax landscape, understanding this trap is crucial for making informed financial decisions!
1. What is the 60% Tax Trap in the UK?
The 60% tax trap in the UK catches many high earners by surprise. It’s not an official tax rate but rather an “effective” rate that impacts those earning between £100,000 and £125,140.
Here at Morrinson Wealth, we’ve seen this surprise more than once. For every £2 you earn above £100,000, you lose £1 of your personal allowance, which normally offsets tax. Combined with the standard tax rate, this results in an effective 60% rate on income within this range.
A recent client learned the hard way when a small pay increase ended up heavily taxed. He hadn’t expected his earnings to dip into this costly trap, and the financial impact was frustrating.
To avoid this, we often suggest strategies like salary sacrifice, pension contributions, or charitable donations to keep taxable income below £100,000.
Small adjustments like these can help you avoid the 60% rate and keep more of your hard-earned income.
2. How the Personal Allowance Phasing-Out Works
The phasing out of the personal allowance creates a hidden tax hurdle for high earners in the UK. As soon as income exceeds £100,000, the personal allowance begins to shrink—£1 is lost for every £2 earned above this limit.
This means that between £100,000 and £125,140, an effective 60% tax rate applies to any extra income.
At Morrinson Wealth, we’ve observed how this can create unexpected challenges. One client was excited about a well-earned bonus, only to discover that it pushed them into this income range.
The result? A significant chunk of the bonus went to taxes rather than savings. Small changes like bonuses or salary bumps can lead to much higher effective tax rates, a reality we see catching people off guard more often than you’d expect.
To navigate this, some look into options like pension contributions to help keep income below that threshold.
3. Effective Tax Rate vs. Marginal Tax Rate
The marginal tax rate is the tax you pay on your next pound of income, while the effective tax rate is the average rate across your entire income.
Many people focus on the marginal rate, but effective tax can give a clearer picture of total tax impact. In the UK, someone in the 40% higher tax band might still have an effective tax rate lower than that, due to allowances.
However, certain income levels can create unexpectedly high effective rates.
For instance, as we’ve seen here at Morrinson Wealth, income over £100,000 triggers a loss of personal allowance, resulting in an effective rate of 60% on income between £100,000 and £125,140.
National Insurance adds to this, with rates at 12% up to £50,270 and 2% beyond that. This combination can make the effective tax rate much higher than expected.
4. Income Thresholds and Allowances to Watch
In the UK tax system, specific income thresholds can significantly affect your tax rate and available allowances.
The £100,000 mark is particularly important, as earning above this means a gradual loss of the personal allowance, which phases out completely at £125,140.
This results in an effective 60% tax rate on income within this range due to the combination of lost allowances and higher income tax.
We’ve observed that changes in income can catch people by surprise. For example, a family with one earner making over £50,000 may face the High-Income Child Benefit Charge, which gradually reduces the benefit if one parent’s income exceeds this amount.
National Insurance rates, too, change at certain levels: 12% up to £50,270 and 2% beyond, adding to the overall tax impact.
These thresholds and charges are key to consider in planning to avoid unpleasant surprises.
5. Strategies to Minimise the 60% Tax Impact
Minimising the 60% tax impact requires careful planning around income and tax relief opportunities.
Salary sacrifice and pension contributions are popular methods; by directing part of your income into a pension, you reduce your taxable salary, potentially keeping it below the £100,000 threshold. This can preserve your personal allowance and keep your effective tax rate lower.
We’ve seen clients benefit from charitable donations as well. Donations to eligible charities can qualify for tax relief, effectively reducing your taxable income.
For some, strategically timing bonuses and dividend payments can also help. For instance, delaying a bonus to the following tax year could prevent it from pushing your current year’s income over £100,000, thereby avoiding the 60% tax trap.
These small adjustments can make a noticeable difference in the final tax bill, giving you more control over your income’s tax impact.
6. Tax-Efficient Investment Options
Tax-efficient investments can help grow wealth without increasing tax burdens.
ISAs (Individual Savings Accounts) allow you to invest up to £20,000 annually, with no tax on gains or income—ideal for low-risk, long-term savings.
For those willing to take on more risk, Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS) offer tax benefits, including 30% income tax relief and tax-free growth. These schemes encourage investment in smaller UK businesses but involve higher risk due to their start-up focus.
We’ve seen how balancing these options can be beneficial. While ISAs offer stable growth, VCTs and EIS can yield higher returns, albeit with increased risk. Knowing your risk tolerance can help you choose the best mix for tax-efficient investing.
7. Consulting a Tax Adviser: Is It Worth It?
For high-income earners, consulting a tax adviser can be a game-changer. Professional tax advice offers tailored strategies to manage income, optimise allowances, and avoid pitfalls like the 60% tax trap.
Advisers bring insight into complex tax rules, helping clients use tools like pension contributions and charitable donations to reduce taxable income effectively.
We’ve seen cases where a single overlooked allowance led to unexpected tax charges. An experienced adviser can spot these missed opportunities, ensuring you don’t pay more tax than necessary.
8. Future Changes to the Tax Code and What to Expect
Keeping up with potential tax code changes is essential, especially for high earners who may be impacted by shifts in income thresholds and allowances.
Upcoming budgets might freeze personal allowances or adjust tax bands, effectively increasing tax for many as inflation pushes up earnings.
We’ve noticed that staying informed helps clients adapt smoothly. Regularly checking HMRC updates or consulting a tax adviser can provide insights into any new reforms.
Simple actions, like revisiting your income structure or investment plans, can make a big difference in maintaining tax efficiency amidst evolving policies.
Conclusion
Navigating the UK’s 60% tax trap can feel overwhelming, but with the right strategies, it’s possible to reduce your tax burden and maximise your financial well-being.
Take action by reviewing your income structure, making smart investments, and consulting with a tax adviser if needed.
Planning ahead will help you make the most of your hard-earned income in 2024 and beyond.
References
HM Revenue and Customs (2024) Income Tax Liabilities Statistics: Tax Year 2021 to 2022 to Tax Year 2024 to 2025, published June 27, 2024. This report includes projections on the number of income taxpayers and their distributions. Available at: https://www.gov.uk/government/statistics/income-tax-liabilities-statistics-tax-year-2021-to-2022-to-tax-year-2024-to-2025/summary-statistics (Accessed: 28 October 2024).
UK (2024) Income Tax Rates and Allowances, updated April 2024. This page outlines the current personal allowance, income tax bands, and tapering thresholds for the 2024/25 tax year. Available at: https://www.gov.uk/income-tax-rates (Accessed: 28 October 2024).
UK (2024) National Insurance Contributions: Rates and Thresholds, updated April 2024. This page provides detailed information on employee and employer NICs rates and thresholds for the 2024/25 tax year, including recent budget updates. Available at: https://www.gov.uk/national-insurance (Accessed: 28 October 2024).
UK (2024) Tax-Efficient Investment Options, updated April 2024. This page includes information on Individual Savings Accounts (ISAs), Venture Capital Trusts (VCTs), and Enterprise Investment Schemes (EIS), highlighting annual allowances and tax relief benefits. Available at: https://www.gov.uk/individual-savings-accounts (Accessed: 28 October 2024).
UK (2024) High-Income Child Benefit Charge, updated April 2024. This page explains the High-Income Child Benefit Charge for individuals earning over £50,000, including the tapering of benefits as income rises. Available at: https://www.gov.uk/child-benefit-tax-charge (Accessed: 28 October 2024).
UK (2024) Tax on Dividends, updated April 2024. This page explains the taxation of dividends, including rates and allowances for the current tax year. Available at: https://www.gov.uk/tax-on-dividends (Accessed: 28 October 2024).