As someone earning in excess of £100,000, you’ll likely face considerable challenges, and perhaps some anxiety, as you plan for your specific financial goals — whether that’s aiming for a comfortable retirement, buying your dream home or passing on your wealth to the next generation.
In fact, according to the Saltus Wealth Index, conducted by Saltus financial planning and investment management firm, 61% of high-net-worth individuals (HNWIs) admit to feeling underlying anxiousness, in terms of prospects relating to their own wealth.
Although the opportunities that arise may be complex, there are some expert methods that can be applied to achieve a particular financial goal — one of which includes making use of your pension and reducing your tax burden.
Of course, the best course of action is to seek professional, financial advice. But in this article, we’ll explain two ways you can make the most of your pension.
Pension contributions via salary sacrifice
When you earn over £50,270, as a higher-rate taxpayer, you’ll be taxed at 40% in income tax and an additional 2% in National insurance — on any income over this threshold.
For example, if you were paid a £1,000 bonus by your employer, only £580 will arrive in your bank account after tax has been deducted.
However, you can overcome this by using your pension.
Most employers pay pension contributions via a method called salary sacrifice, meaning any contributions are gross of all tax, avoiding the 40% in income tax and all national insurance.
Using the example above, the same £580 contributed to your pension, will receive an immediate uplift of £420 in tax relief — a 72% return. When you apply this to the maximum £40,000 annual contribution you can make to your pension (as of 2021/22 and assuming you aren’t tapered), you’ll receive £16,800 in tax relief.
Avoiding the 60% tax trap
When you earn over £100,000, you can find that a portion of your income is effectively taxed at 60%. This is known as the 60% tax trap.
It can be especially disheartening for those who receive large bonuses, and break through the six-figure barrier, only to find it’s ravished by taxation.
So how does it work? And most importantly how can it be avoided?
First of all, here’s a breakdown of the current income tax rates for England, Wales and Northern Ireland, based on earnings of:
- £0 to £12,570 — Personal allowance (no income tax payable);
- £12,571 to £50,270 — Basic tax rate: 20%;
- £50,271 to £150,000 — Higher tax rate: 40%; and
- Over £150,000 — Additional tax rate is 45%.
When your income reaches £100,000, your personal allowance is gradually cut by £1 for £2 of income earned over this amount. Once your income reaches £125,140, you lose your tax-free personal allowance completely.
If you were awarded an additional £1,000 bonus, this is taxed at 40%, leaving you with £600. In addition, you’d lose £500 from your tax-free personal allowance, meaning that £500 will also be taxed at 40%. This will cost you a further £200.
As a result, your £1,000 bonus has suffered from an effective 60% tax rate, meaning you’ve paid £600 in tax and are left with just £400.
However, you can use your pension to get your money back, regaining your personal allowance, and reducing your taxable income.
Theory in practice – 60% tax trap
If you were earning £125,140, for example, you’ll lose your entire tax-free personal allowance. However, if you make a pension contribution of £20,112, the government will apply £5,028 in basic tax relief.
This is paid straight into your pension, taking the total contribution to £25,140. A further £5,028 can be claimed in higher-rate relief on your tax return.
As such, this pension contribution means your taxable income will reduce by £25,140, taking you back down to taxable earnings of £100,000.
You’ll regain your £12,570 personal allowance, which means you’ll save a further £5,028 in tax. This equates to a total benefit of £15,084, simply by putting your income into your pension – a strategy well worth considering.
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.
