Sometimes earning more money can actually make you worse off due to the UK having a marginal rate tax system.
Think about the following example. Suppose you earn £48,000 per year in 2019-20, which means that your earnings (over £12,500) are just within the 20% Basic Rate tax bracket.
However, in the following financial year, you get a generous pay rise of £12,000, taking your income up to £60,000. That sounds great, but then you look at the sums more closely.
In 2019-20, £50,000 is now the threshold after which your earnings start paying 40% Income Tax. So, £4,000 out of that £10,000 pay-rise will disappear to the taxman before you even see it.
Some people find it a bearable thought to pay that extra tax. Yet you also need to consider what happens to your money, in real terms, if you also have children who receive Child Benefit.
Suppose, for instance, that you have two children under 18. For each £100 of your income between £50,000 and £60,000, you will need to pay back 1% of your Child Benefit.
So, let’s look at your £10,000 pay rise again. Since you now earn £60,000, all of that £10,000 pay rise will be subject to that Child Benefit reduction. In real terms, that amounts to you having to repay 100% of your Child Benefit (i.e. £10,000 / £100 = 100).
It is because of significant tax “penalties” like these that many people are interested to know whether it is possible to legitimately avoid the Higher Rate tax band. The good news is that in many cases, it is possible with some careful financial planning.
Let’s take a look at some possible strategies to help you if you are facing a situation similar to the one described above. Please note that this content is for information purposes only but we will be happy to discuss your individual circumstances should you be interested in pursuing these areas further.
In 2019-20, you can normally put up to £40,000 per year into your pension without facing tax (or up to 100% of the value of your salary – whichever is lower). This “Annual Allowance” is a useful option when thinking about reducing your income tax, because you could theoretically put income which would be taxed at the Higher Rate straight into your pension (where the government actually “tops it up” via tax relief).
For instance, suppose you earn £55,000 in 2019-20. If you simply take everything as salary then £12,500 would likely be tax-free (your “Personal Allowance”), whilst £37,500 would be taxed at 20%. £5,000 would be taxed at the 40% Higher Rate.
If, however, you make a £5,000 pension contribution, then that 40% which would have gone to the Government instead goes into your pension pot in the form of tax relief.
Technically, some people could potentially avoid the Higher Rate tax band altogether even if their earnings continued to increase up to nearly £90,000. This is because, as mentioned previously, you have an Annual Allowance of £40,000 which you can put into your pension without incurring a tax charge. So, it is possible that you could earn £90,000 and take home £50,000 as salary, whilst putting the other £40,000 into your pension.
It is always best to discuss this with a Financial Planner first, to make sure that your pension contribution strategy is lining up correctly with your overarching financial goals.
So, you can put up to £40,000 per year into a pension to reduce your tax liability. However, what can you do if you have already used up all or part of your Annual Allowance in 2019-20?
There could still be some options available. For instance, you might be able to take advantage of your unused allowances from the previous three years.
Suppose, for instance, that you only used up half of your £40,000 allowance in 2018-19. In this situation, it could be possible to put £60,000 into your pension in 2019-20 by combining the previous year’s allowance with the current one.
It might not be a long-term solution, but you should certainly consider unused allowances if you have spare funds available.
Have you missed any contributions to your National Insurance (NI) record over the last six years? If so, then you could consider diverting some of your income in this direction to build up your State Pension, rather than simply letting it fall into the taxman’s pockets.
In 2019-20, you need at least 35 qualifying years of NI contributions to receive the full new State Pension when you reach your legal pension age. This could amount to £8,767.20 per year in retirement income, so it’s well worth taking a look at if you have gaps in your record.
If your income exceeds £100,000, then you will need further tax planning in addition to the above considerations regarding the Higher Rate tax bracket.
For instance, whilst many Higher Rate taxpayers will still be entitled to their £12,500 Personal Allowance in 2019-20, those who earn over £100,000 will see their allowance reduced by £1 for every £2 over this threshold.
As an example, suppose you earn £100,000 and receive a pay rise of £10,000 which increases your income to £110,000. That extra £10,000 will likely be taxed at the Higher Rate (40%), which leaves you with £6,000.
However, you would also see £5,000 of your Personal Allowance disappear. That means that £5,000 out of your new £10,000 pay rise would now also be taxed.
If you would like to discuss this in more detail, please do get in touch.
