How to avoid the fiscal drag “stealth tax” amid ongoing income tax threshold freeze

Income tax thresholds have now been frozen for over five years, dragging millions of Brits into higher tax brackets as their earnings increase but the thresholds do not – a process called fiscal drag.

The freeze began in the 2022/23 tax year after then-chancellor Rishi Sunak said in his 2021 Autumn Budget that a temporary freeze on income tax thresholds would keep them at 2021/22 levels until the 2025/26 tax year.

However, as successive chancellors have tried to find ways to raise money, they have each decided to keep thresholds frozen. Jeremy Hunt extended the freeze until 2027/28 in his 2022 Autumn Budget.

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Current chancellor Rachel Reeves then extended the freeze again in the 2025 Autumn Budget, meaning earnings will be taxed at 2021/22 levels until at least the 2030/31 tax year despite experiencing a decade of inflation.

These freezes mean the tax thresholds in England, Wales and Northern Ireland will remain at the following levels until at least 2031.

Taxpayers will begin losing the personal allowance once they earn more than £100,000. It decreases by £1 for every £2 of adjusted net income above £100,000, meaning the personal allowance is lost entirely once your taxable income is £125,140. This is known as the 60% tax trap.

As most people with an income of over £12,570 pay income tax, freezing thresholds affects millions of people.

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

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

The government is forecast to be raking in an additional £55.5 billion in the 2030/31 tax year alone.

How much will fiscal drag cost me?

If you are a Brit in the UK who earns more than £12,570 a year, you will be worse off thanks to income tax threshold freezes. But how badly you are affected will depend on how much you earn.

Fiscal drag is expected to cost basic-rate (20%) taxpayers up to £700 in the 2026/27 tax year alone as the personal tax-free allowance has not grown with inflation, according to research by AJ Bell.

By the time thresholds are planned to start increasing with inflation again in 2030/31, that figure will have risen to around £960.

These figures are even more extreme for those on the higher (40%) rate of income tax. This group will be forking out as much as £3,500 more in tax in the 2026/27 tax year than if thresholds had increased in line with inflation.

By 2030/31 the higher rate threshold should be approaching £70,000 had it tracked inflation, but it is set to remain at just over £50,000, AJ Bell’s analysis shows.

The following table compares the income tax forecast to be paid in the 2030/31 tax year using 2021 thresholds and projected inflation-linked thresholds for two example salaries.

Source: AJ Bell

As the table shows, the cost of fiscal drag is significant, as someone on a salary of £35,000 will be £961 worse off in the 2030/31 tax year thanks to threshold freezes.

That difference is even more pronounced for the higher earner on £75,000 in the higher-rate tax band. The cost of fiscal drag for them is almost £5,000.

How frozen thresholds have worsened the 60% tax trap

The £100k or 60% tax trap is a controversial quirk of the tax system, and more people than ever are set to fall victim to it thanks to fiscal drag. Two million taxpayers will be hit by the £100k tax trap by 2026/27.

Once your earnings reach £100,000, a portion of your income becomes subject to what is effectively a 60% tax rate.

This happens 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.

That means that for every £100 you earn in this bracket, £40 is deducted in income tax, while another £20 is taken as you lose your personal allowance.That translates to a marginal tax rate of 60% on earnings between £100,000 and £125,140.

Fiscal drag is worsening this issue, as people are being dragged into this bracket as their wages rise but the tax thresholds don’t.

Meanwhile, fiscal drag can be even more damaging for higher earners that currently access certain benefits like free childcare hours. This is entirely revoked the moment you go over the household income threshold of £100,000.

How to beat income tax threshold freezes

While there is little you can do to stop fiscal drag entirely, there are ways to mitigate its effects 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.

That does not mean saying no to a pay rise, but may mean delaying when you can use that money.

1. Make pension contributions

One way to beat fiscal drag is by increasing your pension contributions as these receive tax relief, meaning you can effectively claw back income tax.

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

On that final section of your earnings, you get £6 in your pay packet for every £10 you earn. However, if you were to put it into a pension, you would get tax relief on the full £4,729. The catch is that you can’t access this money until retirement.

This may make sense for some people who do not need that extra income right now, helping them lower their tax bill while putting more away for their retirement.

2. Consider salary sacrifice

Salary sacrifice works in a similar way to increasing your pension contributions, as both methods can reduce your taxable income, making it more tax-efficient.

Salary sacrifice can include pension savings, but you can also use salary sacrifice for other benefits like buying an electric car or a bicycle 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 Rob Morgan, chief investment analyst at Charles Stanley Direct.

3. Make sure to use your ISA allowance

An ISA allows all UK adults to save up to £20,000 in cash or investments each year without being taxed on the interest earned or gains realised.

These can help you avoid some of the consequences of fiscal drag by stopping your income from savings and investments becoming subject to higher savings interest tax, dividend tax, and capital gains tax rates.

Any money you make over your tax-free allowances from your investments or savings interest held in non-ISA accounts will count as income for tax purposes.

That can drag you into a higher tax bracket and foot you a bigger tax bill than you may have otherwise had.

For example, imagine you had earnings of £50,270 from your job.

Your employment income alone puts you right on the upper limit of the basic rate tax bracket, meaning you are only paying 20% tax on this.

As a basic rate taxpayer, you would get the personal savings allowance of £1,000. The personal savings allowance is £500 for higher rate taxpayers. Additional rate taxpayers don’t have a personal savings allowance.

If you had £50,000 in a traditional savings account (rather than a cash ISA) that earns a 4% interest rate, you would earn savings interest of £2,000 per year.

This means your savings interest will push you into the higher rate of income tax.

This means you will lose half of your personal savings allowance, as it would fall from £1,000 to £500 per year.

This savings interest is then also taxed at 40%, footing you a tax bill of £600.

If you had instead saved this money in an ISA, you would not have to pay any tax at all on the savings interest as any interest earned on cash ISA savings or investment gains made in an ISA are entirely tax-free.