Ruth Emery
Millions of taxpayers face being dragged into a higher salary band due to the ongoing freeze to income tax thresholds, known as fiscal drag.
Despite thresholds having already been unchanged for two years, research suggests almost seven in ten investors are unaware that frozen income tax thresholds could lead to them paying more tax.
Before the 2021/22 tax year, tax bands increased with inflation but they currently don’t, which leaves people finding themselves in higher-than-expected tax bands as wages rise. Tax thresholds were frozen for five years in Rishi Sunak’s Spring 2021 Budget, with former chancellor Jeremy Hunt later extending the freeze to April 2028.
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In the 2024 Autumn Budget, Rachel Reeves confirmed the income tax threshold freeze would remain in place until 2028.
If your salary rises, you could now be dragged into a higher tax bracket. This is known as fiscal drag and it can have a major impact on your spending power. Worse still, some higher earners face being pulled into a 60% tax trap.
“As income goes up, and inflation rises, a larger proportion of earnings falls into higher tax bands,” says Rob Morgan, chief investment analyst at Charles Stanley Direct. “A person effectively gets taxed more on the same earnings in terms of its spending power.”
Worryingly, research from Charles Stanley Direct found that 69% of DIY investors don’t understand fiscal drag. This, says Morgan, “could drag people into paying more tax without realising”.
As of October 2024, the Office for Budget Responsibility (OBR) estimates that four million more people will be paying tax as a result of these changes from 2027/28 onwards, bringing the total number of taxpayers to over 40 million.
We explain what fiscal drag is, how it affects your finances, and the steps you can take to avoid being caught out.
What is fiscal drag?
“Fiscal drag describes the scenario where the tax burden rises behind the scenes as incomes rise but tax bands don’t keep up or remain frozen,” says Morgan.
It’s often described as a ‘stealth tax’ because, on the face of it, it doesn’t seem like an additional tax. No bands or percentages change.
However, assuming that wage growth is at least keeping up with inflation (and, at the moment, it is slightly outpacing it in the UK), freezing income tax thresholds raises more money for the government by bringing more taxpayers into a higher tax bracket.
What are the current income tax thresholds?
In England, Wales and Northern Ireland, the income tax thresholds and rates are detailed in the table below. The tax rate applies to all income earned in each band, so a higher rate taxpayer will pay the 20% rate on the portion of earnings between £12,571 and £50,270, and 40% on any income above that.
Income tax band | Taxable income | Tax rate |
|---|---|---|
Personal allowance | Up to £12,570 | 0% |
Basic rate | £12,571 to £50,270 | 20% |
Higher rate | £50,271 to £125,140 | 40% |
Additional rate | Over £125,140 | 45% |
Scotland has a more complex system, based on these bands:
Income tax band | Taxable income | Scottish tax rate |
|---|---|---|
Personal allowance | Up to £12,570 | 0% |
Starter rate | £12,571 to £14,876 | 19% |
Basic rate | £14,877 to £26,561 | 20% |
Intermediate rate | £26,562 to £43,662 | 21% |
Higher rate | £43,663 to £75,000 | 42% |
Advanced rate | £75,001 to £125,140 | 45% |
Top rate | Over £125,140 | 48% |
So even though it doesn’t sound like a new tax, freezing income tax thresholds is a tax increase in every meaningful sense of the word. More of your spending power is taxed at a higher level.
Income tax thresholds and savings
The situation becomes even more complex if you have significant amounts of savings outside an ISA.
Not only do you pay more tax on savings interest in a higher tax bracket, but your tax-free savings allowance also falls.
On top of that, interest on savings outside an ISA counts towards your income tax calculation.
“A £50,000 salary plus £1,000 savings interest makes you a higher-rate taxpayer, cutting your personal savings allowance to £500 and leaving £500 of interest taxable at 40%,” explains Laura Suter, director of personal finance at AJ Bell.
“The solutions are to use an ISA to shelter savings, pay more into your pension to stay in a lower tax band, or shift savings to a lower-earning partner,” she adds.
The personal savings allowance, which is the amount of interest you can earn on savings tax-free, thresholds are:
Income Tax band | Personal savings allowance |
|---|---|
Basic rate | £1,000 |
Higher rate | £500 |
Additional rate | £0 |
Our “ISAs vs savings accounts” guide explains tax on savings in more detail.
Understanding fiscal drag and beating income tax threshold freezes
Fiscal drag isn’t well-understood by the general public. Charles Stanley Direct’s survey found only half of DIY investors could correctly identify its meaning. Some common misconceptions identified by the survey were:
- 12% think fiscal drag is when Government spending has to fall because of lower tax receipts;
- 11% said it meant that if earnings increase but inflation falls, consumers see ‘fiscal drag’;
- 9% think it means that taxes paid by consumers and businesses create a ‘fiscal drag’ on growth;
- 9% this it means that if bond markets plummet, this creates ‘fiscal drag’;
- A further 9% think it means that if a household income falls and moves down a tax bracket, that is ‘fiscal drag’.
20% said they don’t know what fiscal drag means.
Thankfully, though the phenomenon itself is complex and counterintuitive, there are some simple steps you can take to mitigate the impacts of fiscal drag.
1. Make pension contributions
Pension contributions receive pension tax relief, meaning you effectively claw back income tax.
“It means it only costs £80 to pay £100 into your pension for a basic rate taxpayer and £60 for a higher rate taxpayer,” says Morgan.
2. Consider salary sacrifice
Making contributions via salary sacrifice, if your employer allows it, can make your income even more tax-efficient. Salary sacrifice involves some of your salary going directly into your pension, or towards other benefits such as an electric car, with no tax deducted.
“Through this method you can save on National Insurance as well as income tax, meaning it only costs £68 to pay £100 into your pension for a basic rate taxpayer, and £58 for a higher rate taxpayer,” says Morgan. “Our research found that 59% of DIY investors currently use or plan to use salary sacrifice. Of that, 29% say they use salary sacrifice to put them into a lower income tax bracket.”
3. Make use of your ISA allowance
“For investments and savings, using an ISA can shelter your returns from the taxman and ensure you don’t pay unnecessary tax, and if you are a couple with different levels of income, shifting cash or assets to the lower earner can also help minimise tax,” says Morgan.
Beware of the personal allowance taper
The personal allowance taper affects those whose earnings reach £100,000.
Once this happens, you start to lose your tax-free personal allowance at a rate of £1 for every £2 you earn over the limit. It means the entire allowance is wiped out once you hit £125,140 of earnings. You’re then effectively paying 60% income tax.
Sian Steele, head of tax at wealth management firm Evelyn Partners, warns: “Those approaching or just over the £100,000 income threshold should be aware of potential complexities when considering tax liabilities. Income from savings interest and dividends, for instance, might not be liable to tax itself if it falls within allowances but will count towards adjusted net income and therefore could take someone into the personal allowance taper.”
It can be very tax-efficient to pay cash into your pension to lower your income and escape the personal allowance taper. Once you factor in pension tax relief and any employer matching, there is often very little impact on your take-home pay – and you’ve got the bonus of having more money in your pension pot.
What does fiscal drag mean for the marriage allowance?
If you are in receipt of the marriage allowance, and either you or your partner become a taxpayer or move up a tax band, you will need to cancel it. This will affect spouses and civil partners who are dragged into the basic-rate tax threshold.
Suter explains: “When you become a basic-rate taxpayer you lose the ability to claim the marriage allowance. The marriage allowance is a tax break offered by the government to married couples or those in a civil partnership, and is worth up to £252 a year.
“To claim it one half of the couple must be a basic-rate taxpayer, which means they earn £50,270 or less a year in the current tax year, and the other half of the couple must earn less than the personal allowance, which is £12,570 in this tax year.
“Similarly, if the lower-earning partner finds their income exceeds the personal allowance it means they’ll no longer be able to share it with their spouse via the marriage allowance.”
The person who made the claim for marriage allowance must cancel it, using their Government Gateway ID to process the cancellation.
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