What is the 60% tax trap?
If you earn over £100,000 you may fall into the 60% tax trap. What is it and how can you avoid it?
Getting a pay rise may seem like a reason to celebrate, but for some high earners, it means you are subject to ever-larger taxes imposed on your income.
A term growing in popularity for people in this group is “HENRY”, an acronym that stands for “High Earner, Not Rich Yet”.
It refers to the fact that under UK tax law, being a high earner also tends to mean you are subject to a high marginal income tax rate, as any earnings over £50,271 are taxed at 40%, and any over £125,140 at 45%.
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However, thanks to a quirk of the tax system, there is another hidden tax rate in the UK that only applies to those who earn between £100,000 and £125,140.
These earners can be subject to what is effectively a 60% tax rate on a portion of income as the £12,570 tax-free personal allowance tapers off, once you exceed £100,000.
What is the 60% tax trap?
Income tax in the UK is split into four main tax bands, with a fifth one hidden.
The first is your personal allowance which means you do not have to pay any penny of tax on your first £12,570 of income in a tax year if you earn less than £100,000.
The second is the basic rate of income tax. In this band you will pay 20% on income between £12,570 and £50,270. For most Brits, this will be the highest income tax they will encounter.
The higher rate of income tax charges 40% on earnings between £50,271 to £125,140.
There is also the additional rate of income tax, where you are charged 45% on income over £125,140.
However, a quirk in the UK tax system means an effective 60% tax rate applies once you start earning more than £100,000.
Once you reach this threshold, your tax-free personal allowance starts to taper away at a rate of £1 for every £2 you earn above £100,000. It entirely disappears once you reach the additional rate tax threshold of £125,140.
This means that for every £100 you earn over £100,000 and below £125,140, £40 is deducted in income tax, while another £20 is lost as you lose your personal allowance. In real terms, that translates to a marginal tax rate of 60%.
The effective tax rate on your earnings above £125,140 then returns to 45%, as by this point you will have lost your entire personal allowance.
Furthermore, some people who earn above £100,000 will start to lose access to some government schemes.
For example, the moment you earn a penny over £100,000, you automatically lose access to free childcare hours, worth up to £2,000 a year per child.
If your individual income is £80,000 or more, you will lose Child Benefit entirely through the High Income Child Benefit Charge (HICBC) – you have to start paying some of it back once your individual income exceeds £60,000.
How to avoid the 60% tax trap
In order to avoid the 60% tax trap, you will need to reduce your taxable income.
This does not necessarily mean you should take a pay cut or reject a potential pay rise. Instead, there are legitimate ways to reduce your take-home pay while still seeing your pay increase.
Effectively, what you are trying to do is lower the income you take home to below £100,000 in order to avoid the 60% tax cliff-edge.
One way to do this is by increasing your pension contributions via salary sacrifice.
The government provides tax relief on your pension contributions up to an annual limit of £60,000 (or £10,000 if you earn over £200,000), meaning you do not pay tax on the money you put into your pension.
Not only does this lead to a bigger pension pot, but it also means you lower your taxable income, helping you avoid the marginal 60% tax rate between £100,000 and £125,140.
You could also consider other salary sacrifice schemes. These could include things like the Cycle-to-Work scheme, or leasing an electric car through salary sacrifice.
You can also consider donating to charity via Gift Aid. Doing this will lower your taxable income in the same way that salary sacrifice does, helping you avoid a tax cliff-edge while supporting organisations doing good in the world.
