How to avoid fiscal drag as income tax thresholds remain frozen

Income tax thresholds have been frozen until at least April 2031, dragging millions of Brits into higher tax bands as their earnings increase but thresholds do not.

The process, known as fiscal drag, means as workers’ earnings rise, often to keep pace with inflation, they face larger tax bills.

Historically, income tax bands increased in line with inflation at the start of each tax year, but they are currently frozen at 2022/23 levels.

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This is why fiscal drag is sometimes called a ‘stealth tax’ as while it doesn’t look like taxes have increased, people are paying more tax as their earnings rise.

What are tax thresholds now?

In the 2021 Autumn Budget, then-chancellor Rishi Sunak announced that tax thresholds would be frozen at their 2022/23 tax year levels until the 2025/26 tax year.

The freeze was then extended to 2027/28 by Jeremy Hunt in his 2022 Autumn Budget, and once again to the 2030/31 tax year by Rachel Reeves in her 2025 Autumn Budget.

By the time tax thresholds are scheduled to increase again, the tax bands will have not changed in ten years, despite a decade of inflation.

The Office for Budget Responsibility, the UK’s fiscal watchdog, estimates 5.2 million more individuals will start to pay income tax for the first time between 2022/23 and 2030/31 due to threshold freezes.

Meanwhile, 4.8 million more people will be dragged into the higher tax band and 600,000 more into the additional rate tax band.

The government is forecast to receive an additional £55.5 billion in taxes due to fiscal drag in the 2030/31 tax year alone.

How fiscal drag forces more people to pay a 60% tax rate

A quirk of the tax system in England, Wales, and Northern Ireland means high earners face an effective marginal tax rate of 60% on every £1 they earn between £100,000 and £125,140.

This is because your £12,570 tax-free personal allowance tapers off at a rate of £1 lost for every £2 earned above £100,000 until you reach an income of £125,140 when you return to the usual 45% rate.

Additionally, as soon as you earn £100,000, you lose access to some government benefits like 30 free hours of childcare and Child Benefit. This is often referred to as a cliff-edge.

A growing cohort of earners are facing the 60% tax trap, with HMRC estimating that over 2 million taxpayers will be caught in the trap in the 2026/27 tax year alone.

The problem is being made worse by fiscal drag, as frozen tax thresholds and a failure to raise the £100,000 cliff-edge mean it is becoming easier for higher earners to be dragged into the tax trap zone.

How to beat income tax threshold freezes

There are ways you can mitigate the effects of fiscal drag on your finances.

The main way this can be done is by reducing your taxable income to avoid being dragged into a higher tax bracket or the £100,000 cliff-edge.

That doesn’t mean saying no to a pay rise, but may mean delaying when you can access that money.

1. Make pension contributions

One way to beat fiscal drag is by increasing your pension contributions. Putting money in your pension pot by salary sacrifice may push you down into a lower tax bracket.

For example, for someone who earns £55,000 you will normally pay no tax on the first £12,570 they earn, then 20% tax on remaining earnings up to £50,271, and 40% on the £4,729 left over.

To reduce their tax burden, they may decide that, if they do not need the money right away, they could put the £4,729 that is taxed at 40% into a pension. They would then get tax relief worth around £1,890.

Sarah Coles, head of personal finance at AJ Bell, said: “If you’re worried about tax on your earnings, pensions are a brilliant and tax-efficient option. The money is tied up to the age of 55 (rising to 57 in 2028), but if that suits you, you can get tax relief at your highest marginal rate.”

She adds that this tool can be even more powerful for those who are stuck in the 60% tax trap where you are taxed at a marginal rate of 60% at the same time as losing access to some free childcare hours and having to pay the High Income Child Benefit Charge.

2. Consider salary sacrifice

Pension contributions are not the only thing you can use salary sacrifice for.

Some workplaces allow you to use the scheme to buy other things like electric cars or bicycles while still reducing your taxable income.

3. Make use of your tax-free allowances

When you are dragged into a higher tax band, you may also start paying higher rates of tax on things like capital gains, dividends, and savings interest.

These make investing and saving using an Individual Savings Account (ISA) even more crucial as any income you make on investments or cash held in an ISA is entirely protected from tax.

Every UK adult has a £20,000 ISA limit that refreshes each year. This allowance can be used on cash and/or stocks and shares.

Coles said: “For investments, it pays to take advantage of your ISA allowances to protect yourself from dividend tax and capital gains tax.

“If you’re just making a start, they should be your first port of call and if you already have investments outside an ISA you can move up to £20,000 a year into them using the Bed and ISA process. If you need to hold investments outside an ISA, you can take advantage of your £3,000 capital gains tax allowance each year to realise gains.”

As for savings, moving into a higher tax band means you may lose some or all of your personal savings allowance.

This allows basic rate taxpayers to earn £1,000 of interest from their cash held in a non-ISA savings account a year before paying tax. This falls to £500 for higher rate payers and £0 for additional rate payers.

“For savings, you can use a cash ISA to protect you from income tax on savings interest. You have the full £20,000 allowance in the current tax year so you may want to consider taking advantage before it drops to £12,000 for those under the age of 65 in April next year,” Coles added.