If you live in England, Wales or Northern Ireland, you probably think the highest rate of income tax is 45%. While 45% is the highest ‘official’ income tax rate, the way the tax-free personal allowance is treated means that some people actually pay an effective tax rate of 60% on some of their income.
The tapering of the personal allowance means someone earning between £100,000 and £125,140 faces an effective 60% tax rate on that portion of their income. Here, we explain how the tax trap works and why contributing to a pension could help you manage it.
Income tax and the personal allowance
Firstly, it helps to take a step back and understand how income tax is charged. Most people have a standard personal allowance of £12,570 – that’s the amount of income you do not have to pay tax on each year. If you have a standard personal allowance, the tax rates you’ll pay in each band of earnings are as follows:
Income tax rates and bands – 2024/ 2025
| Band | Taxable income | Tax rate |
|---|---|---|
| Personal allowance | Up to £12,570 | 0% |
| Basic rate | £12,571 to £50,270 | 20% |
| Higher rate | £50,271 to £125,140 | 40% |
| Additional rate | Over £125,140 | 45% |
Source: HMRC Income Tax rates and Personal Allowances
Why the 60% tax trap occurs
Once you earn more than £100,000, however, your tax-free personal allowance reduces by £1 for every £2 that your adjusted net income exceeds £100,000 and is zero if your income is £125,140 or above.
In real terms, this means that for every £100 of income between £100,000 and £125,140, you only get to take £40 home – £40 is deducted in Income Tax, while another £20 is lost by the tapering of the personal allowance. This amounts to a 60% tax rate. Once you’re earning £125,140 or more, you don’t get any personal allowance at all.
So what can you do to sidestep or mitigate the 60% tax trap?
Let’s imagine you earn £110,000 – or £10,000 above the threshold. You would not only pay £4,000 in higher rate tax on the £10,000, but you’d also lose £5,000 of your personal allowance. And with £5,000 of your personal allowance gone, that portion of your income is now also subject to tax at 40%, costing you another £2,000. In other words, of that £10,000, you’d only get to keep £4,000, which equates to a 60% tax rate.
How to reinstate your personal allowance
There is a relatively simple way to mitigate the 60% tax trap – and that’s to save into a pension. If you earn £110,000 and make a gross pension contribution of £10,000, your adjusted net income would fall to £100,000. This would reinstate your full personal allowance and give an effective rate of tax relief of 60% on your pension contribution (or 67.5% in Scotland).
Doing so could also help you in the longer term as you would have boosted your pension pot by £10,000. Thanks to the power of compounded investment returns, this could make a real difference to the value of your pension pot at retirement.
Bear in mind that there is a cap on the amount you and your employer can pay into your pension each year and still get tax relief. For most people, the pension annual allowance is 100% of your UK relevant earnings or £60,000, whichever is lower (this might be tapered if your adjusted income exceeds £260,000). If you exceed your annual allowance, you’ll have to pay an annual allowance charge which essentially claws back any tax relief received on the excess contribution. If you aren’t sure how much your annual allowance is, or you’re concerned about exceeding it, speak to a financial adviser.
Next steps
Understanding how different tax rules might affect you isn’t easy, especially as the rules can change frequently. A financial adviser can help you keep up to speed, explain how the various rules affect your long-term financial planning, and help you decide on the best course of action for you.
Please note:
This does not constitute tax or legal advice and should not be relied upon as such. tax treatment depends on the individual circumstances of each client and may be subject to change in the future. for guidance, seek professional advice.
A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age).
The value of your investments (and any income from them) can go down as well as up, which would have an impact on the level of pension benefits available.
Your pension income could also be affected by the interest rates at the time you take your benefits.
