What is the 100k Tax Trap and How Can You Avoid It
Introduction
As we're sure you're aware, the UK operates with a number of different tax brackets. As a country, we use a system of marginal taxation: the first £12,570 you earn is exempt from tax, from £12,751 to £50,270 you're taxed at 20%, from £50,271 to £125,140 is taxed at 40%, and above that is taxed at 45%.
A common misconception is that the higher rates of tax apply to your entire paycheck. This is incorrect - as you move up the pay scale, the higher rates only apply to the parts of your pay that exceed that amount. This is what's known as marginal tax rates. Which means that you will never take home less money after a pay rise.
Understanding the 100k Tax Trap: What It Is and How to Negotiate It
That being said, after you pass £100k, your nil rate band, ie the £12,570 you earn no tax on, begins to be taken away. It is removed at a rate of £1 for each £2 you earn, so that when you reach £125,140, you lose it entirely and are then paying tax on everything you earn. So there is a period where you are actually paying much more than 45%!
So How Much are You Paying?
The effective rate you're paying as a result of losing out on this allowance is a whopping 62%. Losing your personal allowance brings you up to 60% and then your National Insurance contributions make up the rest.
Example:
Let's use an example. Say you are an individual earning £100,000 per year exactly, and you receive a 20% bonus of £20,000.
From this bonus, immediately £8,000 is lost to standard higher rate tax, payable at 40%.
The double hit though, is that your personal allowance is now also reduced from the full entitlement of £12,570 to £2,570. The reduction of £10,000 means that there is an additional £10,000 of income that sits within the higher rate tax bracket and is subject to 40% income tax. This is equivalent to a further £4,000 of income tax payable.
Finally, there is also the National Insurance contribution payable on the bonus, which is at 2% above the higher rate tax threshold of £50,270, equating to £400 in this example.
So where does that leave us?
Well, the result is an effective tax rate of 62%, with the person taking home £7,600 of their £20,000 bonus!
Avoiding the 100k Tax Trap: Essential Tips for High Earners
So of course, you're probably now wondering what on earth you can do to avoid it. Not that you want to get out of paying taxes, of course - this is about using the legal framework of our income tax system to make sure that you use all incentives the government has put in place for you.
The concessions are there for a reason - it would be foolish for you to not use them for their intended purpose! So what are they?
Pension Contributions
Increasing your pension contributions is a particularly effective way of reducing your taxable salary. By making higher pension contributions you are reducing what you take home today and passing that money on to your future self. This is also untaxed at point of contribution so you get to keep the gross amount you're contributing.
A national insurance reduction is also applicable, giving a potential tax relief rate of up to 62% on pension contributions.
Example
Here's an example. You get a £1,000 pay rise, taking your taxable income up to £101,000. By contributing that pay rise into your pension, you won't enter the 60% tax band, and will therefore get the benefit of a 40% top-up on your contribution too thanks to pension tax relief.
Note that you can contribute up to £60,000 into your pension each year while still enjoying tax relief on your contributions. So there's plenty of space for increases!
Charitable Donations
Of course, by donating money to charity you are also reducing your income and avoiding the tax trap. Similar to pension contributions, these reduce your adjusted net income and can allow you to reclaim some of your personal allowance.
Conclusion
Of course, taxes are complicated and there are often changes to legislation that can be hard to keep track of. Make sure you either keep in touch with your financial adviser, or check these regularly to make sure that you are staying in line with the law.
You can check your cash flow using the Strabo cash flow planning tool, in order to make sure that you're covered with enough income to last you into retirement and beyond.
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