Checklist: What to do if frozen tax thresholds put you in a higher tax bracket

The government’s freeze on income tax thresholds will see millions of people dragged into higher tax bands. 

According to the Office for Budget Responsibility, three million people will be moved into the higher rate of income tax by 2028-29, while a further 400,000 will start paying the additional rate.

The government froze personal tax thresholds in March 2021 in an effort to balance the state’s books, but this has created a fiscal drag where people find themselves in higher-than-expected tax bands as wages rise. Pay growth was 6.6% in the three months to November.

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The stealth tax will see many households pay thousands more in tax than they would have done had thresholds been indexed in line with inflation.

For example, the additional rate of income tax was set at £150,000 in April 2010 and cut to £125,140 in April 2023. If it had risen with wage inflation since, it would now be £224,101, analysis from Hargreaves Lansdown has found.

If your income tax bill is rising, here’s a handy list of seven actions to take to avoid landing in hot water with the taxman, plus how to make the most of tax-efficient schemes and save money.

1, Cancel the marriage allowance 

If you are in receipt of the marriage allowance, and either you or your partner becomes a taxpayer or moves up a tax band, you will need to cancel it. 

Laura Suter, director of personal finance at the investment platform AJ Bell, 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. 

If you can afford it, diverting some of your salary into a pension to remain below the higher-rate tax threshold or personal allowance (for the higher and lower earner respectively) would allow you to continue using the marriage allowance.

2, Repay child benefit

Once parents start earning more than £50,000 they are subject to the Child Benefit High Income Charge. This means they lose 1% of their child benefit payments for every £100 they earn over £50,000. 

If you had two children you’d be entitled to £2,074.80 a year in child benefit in the current tax year. For someone with children, a £1,000 pay rise equals a 10% loss in child benefit, which equates to £207. 

“Frustratingly you can’t just claim the exact percentage of the benefit amount you’re entitled to,” says Suter. “Instead you have to be paid the full child benefit and then the government reclaims some of it by charging you at the end of the tax year.”

Parents should tell HMRC as soon as they realise that they’ll face the charge. The person in the couple with the highest income will be responsible for paying the tax charge, or they can choose to opt out altogether. 

If you choose to receive the benefit and pay the tax charge, you’ll need to fill out a self-assessment tax return and then pay what you owe. 

Alternatively, the higher earner could try to reduce their income below the £50,000 threshold – by making pension contributions.

3, Claim extra pension tax relief 

While you may not be able to claim child benefit and/or the marriage allowance any longer, one perk of a rising salary and entering a higher tax band is the ability to claim more tax relief on your pension contributions.

For some employees, the extra tax relief will be paid automatically into their pension pot. But for others, they will need to claim it. 

It depends on the type of pension scheme you’re in – if you make personal contributions to “relief at source” schemes you’ll need to claim the additional tax relief back from HMRC. Ask your pension provider or HR team if you’re unsure.

Research by Interactive Investor reveals that a third of higher-rate taxpayers could be missing out on an extra 20% tax relief on their pension contributions by failing to claim it. Additional-rate taxpayers can claim an extra 25%.

Alice Guy, head of pensions and savings at Interactive Investor, comments: “Many people assume they automatically get all the pension tax relief they’re entitled to, but for higher-rate taxpayers, that’s simply not the case. Ultimately, this is free money, and not claiming additional tax relief you’re entitled to means you could lose out on thousands of extra income each year.”

You can either claim the extra relief via your tax return or by contacting HMRC directly.  

4, Prepare for a reduced savings allowance 

Once you hit the higher-rate income tax threshold, the amount you can earn in savings interest before paying tax is cut in half. 

Basic-rate taxpayers have a £1,000 personal savings allowance, while higher-rate taxpayers only get an allowance of £500. Additional-rate taxpayers get zero - in other words, they don’t get an allowance at all.

With the best savings rates at 5% or higher, it means a growing number of savers are being taxed on the interest they earn.

The simplest way to avoid paying tax is to make use of your ISA allowance. Cash ISAs protect savings from the taxman so you don’t pay a penny in tax, regardless of your salary or income tax rate.

Another option is to buy Premium Bonds, as any prizes won are completely tax-free.

As with child benefit and marriage allowance, if you can lower your income to go down one tax band, you could benefit again from the tax break.

For example, if you’ve been bumped up into the additional-rate threshold, and earn £127,000, you could put more into your pension or give to charity, and once your income falls below £125,140, you’ll be a higher-rate taxpayer again and receive the £500 savings allowance.

5, Prepare for the higher capital gains tax and dividend rates 

A higher rate of dividend tax awaits those who have become higher-rate or additional-rate taxpayers. Anyone moving up from basic-rate to higher-rate income tax will also be hit with an increased rate of capital gains tax.

“Once you hit the higher rate of income tax, any dividends over the current £1,000 annual tax-free limit will go from being liable for 8.75% tax to 33.75%,” explains Suter.

“It’s the same case for those with capital gains, who will go from paying 10% to 20% tax on their gains over the tax-free limit. It’s an even bigger tax rate on any gains made from second properties, with the rate going from 18% to 28% once you hit the higher rate of tax.”

Once you hit the additional rate of income tax you’ll pay a higher rate of dividend tax of 39.35%. For someone with £500 of dividends over the tax-free limit that means an extra £28 in tax a year, according to AJ Bell.

Be aware of whether you’re likely to hit the higher-rate threshold before you cash in on capital gains – if your income is temporarily higher this year you could delay the gain until the next tax year and pay a lower rate of tax. 

Alternatively, you might want to conduct a “Bed and ISA” transaction now, where you sell assets outside an ISA and re-purchase them inside the tax wrapper. 

If you have investments outside an ISA or pension, look at whether you can transfer them into a tax-efficient account so you don’t pay tax on the returns.

Watch out if you’re near the additional-rate threshold or have significant dividend income, as you could find that your dividend income pushes you into the additional-rate band. 

6, Beware of the personal allowance taper 

This is not related to income tax thresholds, but does affect 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.

7, Check your entitlement to tax-free childcare and additional free hours  

Once you or your partner hit earnings of more than £100,000, you’ll no longer be eligible for tax-free childcare or the full 30 hours’ entitlement of free childcare a week. That includes the extended childcare offering being introduced by the government, with free hours being phased in for children as young as nine months old.

You’ll need to stop claiming the tax-free childcare through your Government Gateway account, and also cancel the 30 hours entitlement.

Suter comments: “You’ll still be eligible for 15 hours of free childcare, but this is claimed by your nursery or childminder on your behalf. This is a sizeable loss of cash and because the cut-off is an immediate ‘cliff edge’, a pay rise taking you slightly above £100,000 can leave you worse off. Combined with the personal allowance taper, it is often better to divert money into your pension to keep your taxable earnings in five figures.”

According to calculations by the accountancy firm BDO, if someone with two children on a salary of £105,000 has made a £5,000 gross pension contribution, they will retain the right to £4,000 in free childcare and make a tax saving of £2,000 (£1,000 in higher-rate pension tax relief plus £1,000 for the re-instated personal allowance).