As you join the company of other high earners, and begin earning over £100,000, you also enter the territory of financial complexities. One such challenge involves the amount of income tax you pay, and how this could rise to an effective rate of 60%.

Read on to find out more about the dreaded tax trap and most importantly, how you can avoid it.

Understanding income tax

Simply put, income tax in the UK is a tax you pay on your income, as implied by its name. This means you pay tax on things like:

• the money you earn from employment or profit made in self-employment
• most pensions, including state pensions, company and personal pensions and retirement annuities
• some state benefits
• rental income
• benefits you get from your job
• income from a trust
• interest on savings over your savings allowance

There are some exemptions from the rule, and therefore things you do not pay tax on.

The majority of people are also eligible for the Personal Allowance which is the amount of income you do not have to pay tax on. The standard Personal Allowance for the tax year 21/22 is £12,570.

The rate of income tax that you pay also varies depending on your earnings, and differs if you live in Scotland. If your earnings are:

• £0 - £12,570 — then there is no income tax payable
• £12,571 - £50,270 — income tax is a basic rate of 20%
• £50,271 - £150,000 — income tax is a higher rate of 40%
• Over £150,000 — income tax is an additional rate of 45%

So, if you are earning over £100,000 then you may think that you’ll only pay income tax at a rate of 40%. However, due to a quirk in the tax system, you inevitably end up paying effectively a tax rate of 60%. And here we explain how.

The 60% tax trap

When you exceed a six-figure sum of income, your Personal Allowance is actually tapered, at a rate of £1 for every extra £2 you earn. This means when you reach an income of £125,140, you lose your tax-free Personal Allowance completely.

Let’s consider you receive a bonus of £1,000. This takes you over the £100,000 earnings threshold, and this amount will be taxed at the higher rate of 40%. However, as you have exceeded this six-figure, your Personal Allowance is then reduced by £500. As a result, £500 more of income is also taxed at 40%, costing you a further £200.

In this example, you’re actually left with only £400 from a £1,000 bonus, paying £600 in tax. According to wealth management and financial planning firm, saltus.co.uk, this is what is known as the 60% tax trap.

How to avoid the tax trap

There’s one surprising way that you can avoid the 60% tax trap, and that is by making the most of your pension contributions.

You should consider taking the same amount that you have received as a bonus, like the £1,000 example above, or in other cases the income that you have earnt that exceeds over £100,000, and place it into your pension pot instead.

Firstly, this will take your income back to the £100,000 threshold, and so keeping your full personal allowance intact (£12,570 as of the tax year 21/22). This means that no more of your income is taxed further.

Plus, by placing this amount into pension savings, you could also receive a basic-rate tax relief from the government. This is also based on the rate of income tax you pay (again, it differs in Scotland), and so:

• Basic-rate taxpayers get 20% pension tax relief
• Higher-rate taxpayers can claim 40% pension tax relief
• Additional-rate taxpayers can claim 45% pension tax relief

With some expert financial planning, you can not only benefit from avoiding the 60% tax trap, but also gain from the government’s tax relief — all through using your pension.

Disclaimer: Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.