Reclaiming Personal Allowance: Avoiding the 60% tax trap

As individuals, we all want to make the most of our hard-earned money while minimising our tax liabilities. One effective way to achieve this is by reclaiming lost personal allowance through pension contributions. By understanding how pension contributions can help you maximise your tax efficiency, you can make informed decisions about your financial future.
In this article, Independent Financial Adviser, Ryan Caisley, explores the concept of the personal tax allowance, its relationship with pension contributions, and how you can take advantage of this strategy:

Personal allowance refers to the amount of income you can earn before you start paying income tax. For the 2023/2024 tax year, the personal allowance is £12,570. However, if your adjusted net income exceeds £100,000, for every £2 your income is over the £100,000 you lose £1 of your Personal Allowance. This means that if your annual income exceeds £125,140, you lose all of your allowance.

Consequently, anybody with an income between £100,000 and £125,140 can fall foul of a 60% tax charge, which is often referred to as the ‘Tax Trap’. This also means that you will have to complete a Self-Assessment tax return.

In theory, if you earn £110,000 (£10,000 above the threshold), you will pay the higher rate tax of 40% on the £10,000, but you’d also lose £5,000 of your personal allowance. The impact of losing £5,000 of your personal allowance means that portion of your income, which was previously charged at an effective tax rate of 0% is now also subject to tax at 40%, costing you another £2,000. Consequently, of that £10,000, you’d only get to keep £4,000, which equates to a 60% tax rate.

Reclaiming lost Personal Allowance

One way to reclaim lost personal allowance is by making pension contributions. The government provides tax relief on pension contributions, and they can be used to reduce your overall taxable income, which also means being able to reclaim any lost personal allowance.

Saving into a pension is one solution which can mitigate the 60% tax trap. In the above example of earning £110,000, if you earn £110,000 and make a gross pension contribution of £10,000, your adjusted net income would fall to £100,000 thus reinstating your full personal allowance which effectively provides you with 60% rate of tax relief on your pension contribution.

Savings you could miss

In this scenario, if you did not make the pension contribution on the additional £10,000 above the £100,000 you would be effectively paying £6,000 of tax, as explained above. However, should you make a £10,000 gross pension contribution (which is £8,000 net) you would be reducing your tapered earnings to £100,000 which results in a higher-rate tax saving of £4,000 plus reinstating your personal allowance, saving a further £2,000 of potential tax, not to mention you also have £10,000 in your pension.

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 reduced or “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.

As always, if you have any concerns or questions on your portfolio, please don’t hesitate to get in touch.

— Ryan Caisley

Independent Financial Adviser

Call: 01633 851805

Email: [email protected]

Office: 5 & 6 Waterside Court, Albany St, Newport, NP20 5NT

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The contents of this article do not constitute financial advice in any way; if you have any concerns about your finances you should talk to your financial adviser. The value of your investments can go down as well as up.

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Reclaiming Personal Allowance: Avoiding the 60% tax trap
Ryan Caisley 6 July 2023
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