More people are being dragged into paying higher rates of income tax – but there are ways to reduce this bill
Frozen tax thresholds are dragging millions more people into paying higher rates of tax with many looking for ways to cut their bill.
The Office for Budget Responsibility (OBR) estimates that by 2028/29, the freeze on tax thresholds will lead to 2.7 million people being more moved to the higher rate of income tax (40 per cent) and another 600,000 paying the additional rate (45 per cent).
As a result, there will be a large increase in people paying thousands more in income tax than they would have done had thresholds been risen in line with inflation.
However, there are ways to keep your tax bill low, including by boosting your pension pot. We explain how.
What is income tax and who pays it?
Income tax is paid on earnings from employment and profits from self-employment during the tax year, which runs from 6 April to 5 April the following year.
It is also paid on some benefits and pensions, income from renting out property, and returns from savings and investments above certain limits.
Currently, the basic rate is 20 per cent and is paid on annual earnings between £12,571 and £50,270.
The higher rate is 40 per cent and is paid on earnings between £50,271 and £125,140.
The additional rate is 45 per cent and paid on earnings over £125,140.
Once you earn more than £100,000, you also start losing the £12,570 tax-free personal allowance. You lose £1 of your personal allowance for every £2 that your income goes above £100,000.
Some income tax rates are different in Scotland, for example, a new 45 per cent band took effect in April last year. at the same time, the top rate rose from 47 per cent to 48 per cent.
Who will be impacted the most by frozen thresholds?
The next three years will see more and more people enter higher tax brackets, unless the freeze on extending tax brackets, which is in place until April 2028, is lifted.
Those earning between £100,000 and £125,140, where the tapering of personal allowance creates a “cliff edge” tax problem, will be particularly impacted by the issue of frozen thresholds.
Tracy Crookes, chartered financial planner at Quilter Cheviot, said: “As personal allowances decrease within this income range, the effective tax rate can spike significantly, especially when combined with the loss of other benefits such as child benefit.
“Many families in this bracket find themselves facing an effective marginal tax rate of up to 60 per cent or higher.
“This situation is even more challenging for parents with young children, as crossing the £100,000 threshold also results in losing access to 30 hours of free childcare, further compounding the issue.”
While a higher tax rate inevitably impacts the money you take home, there are several reliefs and allowances available that can work in your favour and help you maximise your income.
How can pensions help you keep a hold on more of your cash?
Pension saving is a particularly good way to protect your income by reducing your tax bill, while also allowing you to save for the future, Dean Butler, managing director for retail direct at Standard Life, said.
Former pensions minister and partner at LCP Sir Steve Webb agreed. He said: “Saving into a pension brings tax advantages for most people but is particularly attractive for those who are on higher incomes.”
But how?
Claim extra pension tax relief
UK taxpayers are entitled to tax relief on their own pension payments based on the rate of income tax they pay, with most getting a 20 per cent top-up from the government.
This means it only costs £80 to pay £100 into your pension, Butler said, adding: “Higher-rate taxpayers can reclaim an extra 20 per cent tax on pension contributions for a total of 40 per cent tax relief, while additional rate taxpayers are entitled to an extra 25 per cent.
“However, higher rate relief doesn’t always happen automatically – you might have to claim it.”
Depending on how you make your payments, you may need to complete a self-assessment tax return, he said.
You’ll then either get the tax back as a rebate at the end of the year or through an adjustment to your tax code. Tax relief can only be claimed back for the last four tax years.
Paying into your pension to recover your tax-free personal allowance
Paying into a pension plan can offer a solution to the loss of your personal allowance.
Doing so would allow you to reduce your adjusted net income, helping you recover some or all of your personal allowance, depending on how much you put in.
Charlene Young, senior pensions and savings expert at AJ Bell, said: “Making a pension contribution can lower adjusted net income, retain their personal allowance and benefit from 60 per cent tax relief on the slice of their extra income paid into the pension.”
Increase your pension contributions to keep more of your child benefit
As of April 2024, families with an income of £60,000 or over are subject to the high-income child benefit tax charge.
This means a reduction in the amount of child benefit available, with the charge standing at 1 per cent of your child benefit for every £200 of income between £60,000 and £80,000.
Butler said: “By the time you or your partner earn more than £80,000, you lose your child benefit with the charge equalling your full amount of child benefit.
“Higher earners could consider increasing pension contributions to reduce your adjusted net income – by reducing this income to below £80,000, you could get some or all of your child benefit back, while also saving for your future.”
Claiming child benefit also gets you national insurance credits towards your state pension, and your children will automatically get a national insurance number when they turn 16, Ms Young pointed out.
Consider salary sacrifice
Crookes said contributions made via salary sacrifice reduce your taxable income, meaning you pay less tax and national insurance.
If your employer offers to match or top up your contributions, your money could stretch even further, she said.
Butler said: “Some workplace pension schemes offer salary sacrifice. This means agreeing to reduce your salary by a certain amount, in exchange for a pension contribution made by your employer.
“With this reduction in salary resulting in lower national insurance and income tax, it can be an effective way of keeping more of your income whilst also saving more for retirement.
“It’s important to note, however, that salary sacrifice can impact mortgage applications and payments based on your salary like statutory maternity pay, so it might not be right for everyone.”
