The personal allowance tax trap: 60% tax? Isn’t the top rate 45%?

Published  14 February 2023
   10 min read

Craig Muir, Senior Intermediary Development and Technical Manager at Royal London, explains why some clients might pay 60% tax, and how you can help them.

I’m sure many of your clients are astounded to find they’re paying 60% tax on part of their earnings especially when their belief is the top rate of tax is 45% and they should only be paying 40% tax. The good news is, with careful planning and your help, they can receive 60% tax relief and even higher in some instances.

60% tax

The personal allowance is reduced by £1 for every £2 of income above £100,000. This means that when income is £125,140 or more, the personal allowance will be nil.

The effective tax rate for income between £100,000 and £125,140 is 60% because in addition to paying 40% tax on any income above £100,000, there's the impact of losing some or all of the personal allowance and paying 40% tax on that too.

This is often referred to as the personal allowance tax trap.

How to get 60% tax relief (or even more)

The key to this is adjusted net income. Not to be confused with adjusted income, which is used when calculating the tapered annual allowance.

Adjusted net income, on the other hand, is total taxable income before any personal allowances and less certain tax reliefs, for example: trading losses: donations made to charities through Gift Aid, gross pension contributions to a net pay or relief at source pension scheme.

Therefore, a pension contribution can get clients out of the personal allowance tax trap as it helps by reducing adjusted net income.  This is particularly useful for those impacted by the loss of their personal allowance when earning above £100,000.

Case Study

Let’s look at how this works in practice.

Candia is 56, is employed, resides in England and has just received a large pay rise. Once her current workplace pension contributions have been deducted her adjusted net income is £125,140.  Her financial adviser has informed her that she’ll be paying the equivalent of 60% tax on the top £25,140 of her income which she was completely unaware of and is very keen to avoid if possible.

The adviser explains that any pension contributions made by an individual or on their behalf, whether to an occupational pension scheme or to a personal pension, will reduce their adjusted net income. 

Candia’s adviser runs through the numbers and shows her the difference a personal pension contribution of £25,140 can make. He demonstrates this using the table below:

Pension contribution Before After
Taxable income £125,140.00 £125,140.00
Personal allowance - £12,570.00
Employee NI £6,021.40 £6,021.40
Employer NI £16,013.52 £16,013.52
Income tax £42,516.00 £32,460.00
Personal contribution (net) - £20,112.00
Employer personal contribution - -
Net income £76,602.60 £66,546.60

Candia’s adviser explains that a net pension contribution of £20,112 will receive basic rate tax relief and will be grossed up to £25,140. This pension contribution reduces the adjusted net income to £100,000 and Candia’s full personal allowance will be restored. The gross pension contribution of £25,140 results in a reduction to income after tax of £10,056. The difference is £15,084, giving an effective tax relief rate of 60% [£15,084/£25,140 = 60%]. This contribution, together with Candia’s contribution to her workplace scheme, won’t exceed her annual allowance.

Note that the pension contribution of £25,140 extends the amount of income subject to basic rate tax by this amount. So, £62,840 [£37,700 plus £25,140] is subject to basic rate tax, with the balance of taxable income of £49,730 subject to higher rate tax.

Candia is not convinced as she is focused on the bottom line where her net income has reduced by over £10k from £76,602.60 to £66,546.60.  She understands she has an extra £25,140 in her personal pension but she isn’t happy about the reduction in her net income.

However, her adviser explains that as she is a higher rate tax payer, she can claim another 20% tax relief from HMRC providing an additional £5,028 net income. Plus, as she’s over 55, she could take 25% PCLS from the pension contribution of £25,140. That would add another £6,285.  Her net income would then increase to £77,859.60, some £1,257 more than it was going to be before the pension contribution, and she’ll still have £18,855 in her personal pension. 

Her adviser then explains an additional tax saving can be made if her employer uses salary exchange:

Pension contribution Before After
Taxable income £125,140.00 £100,000.00
Personal allowance - £12,570.00
Employee NI £6,021.40 £5,518.60
Employer NI £16,013.52 £12,544.20
Income tax £42,516.00 £27,432.00
Personal contribution (net) - -
Employer personal contribution - £28,609.32
Net income £76,602.60 £67,049.40

Candia’s adviser explains if her employer makes an additional pension contribution of £28,609.32 (100% of the employer NI saving of £3,469.32 plus salary exchange of £25,140) using salary exchange, her income will reduce by £9,553.20.  The difference is £19,056.12, giving an effective tax relief rate of 67% [£19,056.12/£28,609.32 = 66.61%].

Candia is ecstatic she no longer has the 60% tax charge.

Because different tax bands and rates apply in Scotland the effect of tax relief is even higher.

Helping your clients

If you have clients who have lost their personal allowance, then using a pension contribution could help them to reduce their tax and recover their personal allowance while increasing their pension savings. Pay particular attention to clients who have had a large pay increase, bonus or redundancy payment as they may not be aware they have fallen into the personal allowance tax trap. 

For more technical content and support as tax year end approaches, visit our tax year end hub.