Hidden tax trap sees some workers paying 60% of salary to HMRC

More than half a million people are paying up to 60 percent of the top chunk of their salary to the government due to a “tax trap”.

A quirk of the tax system means anyone with a salary from £100,000 to £125,140 is hit by a system that punishes pay rises.

It means they pay an effective tax rate of 60 percent, which is significantly higher than the 45 percent rate imposed on the very highest earners.

The problem occurs largely because people lose their right to the Personal Allowance of tax-free income set at £12,570 once they start earning over £100,000.

The rules mean that for every £2 earned above £100,000 they lose £1 of the Personal Allowance. By the time they earn £125,140, the Personal Allowance has fallen to zero.

The combined effect of the 40 percent tax rate for higher earners and the loss of the Personal Allowance means that for every £100 earned over £100,000 the individual effectively loses £60.

Anyone earning over £125,140 is charged the higher rate of tax at 45 percent and not any more because there is no Personal Allowance to lose.

The number of workers falling into the “tax trap” rose by 23 percent from 436,000 to 537,000 between 2021-22 and 2022-23, the latest year for which figures are available, according to a Freedom of Information request.

The figure today is likely to be considerably higher after another year of frozen income tax thresholds and surging inflation.

To make matters worse, parents in this income bracket can be hit even harder. This is because once a parent earns more than £100,000, they lose tax-free childcare and half the 30 hours a week of free care that is available for three and four-year-olds.

This is worth up to £14,500 a year for someone with two children, creating an incentive for parents earning £99,000 to turn down a pay rise so they can hold on to the government benefit.

Mark Incledon, chief executive at Bowmore Financial Planning, urged the Government to fix the tax trap problem.

He told the Telegraph: “Reaching a six-figure salary has long been a major goal for a lot of people. We all understand that this comes with the obligation to pay more tax.

“Unfortunately, if HMRC takes 60p in every pound you earn above £100,000, the lure of getting there is a lot more limited.

“It only disincentivises people from working harder, being more productive and ultimately generating economic growth.”

A Treasury spokesman said: “We are committed to keeping taxes on working people as low as possible while maintaining fiscal responsibility, that’s why we’ve pledged to not raise income tax, National Insurance or VAT.

“We are a government of wealth creation and believe the best way to responsibly improve living standards is through economic growth by guaranteeing stability, stimulating investment, and reforming our planning and skills systems to unlock Britain’s potential.”

Experts at unbiased.co.uk said it is possible to mitigate the effects of the tax trap.

Is it possible to legally avoid the the 60 percent tax trap?

One of the best ways to avoid 60 percent tax is to pay into a pension or increase your payments if you’re already contributing.

By paying more into a pension, you reduce your adjusted net income and can either reduce the amount of you lose or even reinstate it fully if your income falls to £100,000 or less.

Alternatively, you could donate to charity to cut your income to under £100,000 and get tax relief.

Another option is to use salary sacrifice to give up part of your salary for a non-cash benefit such as childcare vouchers or private medical insurance.

Why is boosting pension contributions worth considering?

The first option of contributing to your pension is attractive, as you’re building your pot for later on in life while also benefitting from tax relief.

Depending on how your pension fund performs, you can also benefit from potentially higher returns and over a long time, where your interest earns interest.

However, you should be aware that there are limits to how much you can contribute to your pension each year and get tax relief.

You can contribute the lower of £60,000 or 100 percent of your earnings annually and receive tax relief – if you exceed this, you’ll incur a tax charge.

High earners with an income of £200,000 will likely have a tapered pension annual allowance, which can reduce it to as little as £10,000.

It’s wise to seek expert advice from a financial adviser who can advise on your tax liabilities and pension contributions.