Case Study: Avoiding the 60% tax trap
Ellen is the chief executive of a design agency with an income of £122,000 p.a. in the current tax year.
At the moment she doesn’t make any pension contributions, but is attracted by the new flexibility she has read about online. She also feels that she is paying more Income Tax than expected and has asked EQ for help.
Ellen’s current income tax position
Ellen’s adjusted net income is more than £100,000 which means that her Personal Allowance (the part she pays no Income Tax on) will reduce by £1 for every £2 over this threshold. This means that Ellen’s Personal Allowance will reduce from £11,000 to nil (£22,000/2=£11,000).
Ellen pays Income Tax at 20% on the next £32,000 and £40% on the rest. The table below shows how her Income Tax is calculated.
|Income in this band||Tax due|
|Personal Allowance @0%||£0||£0|
|Basic Rate Band @ 20%||£32,000||£6,400|
|Higher Rate Band @ 40%||£90,000||£36,000|
The £22,000 that Ellen earned over £100,000 has been taxed as follows:
- 40% tax on the lost Personal Allowance (£11,000 x 40% = £4,400)
- 40% tax on the £22,000 which is within the higher rate band (£22,000 x 40% = £8,800)
So this part of Ellen’s income is taxed at 60% (£13,200 tax on £22,000 income).
Make a pension contribution
Ellen’s EQ Wealth Consultant explains that if she makes a pension contribution of £17,600 net, before the end of the tax year, she could save this tax and make provision for her future retirement.
The contribution of £17,600 net will benefit from basic rate tax relief in her pension making it worth £22,000 (the gross amount). This reduces her ‘adjusted net income’ from £122,000 to £100,000 which means that she will get her Personal Allowance back. Not only this, but her Basic Rate Band will grow from £32,000 to £54,000.
As a result of paying £17,600 into her pension (which will immediately increase to £22,000) Ellen’s Income Tax will be calculated as follows:
|Income in this band||Tax due|
|Personal Allowance @0%||£11,000||£0|
|Basic Rate Band @ 20%||£54,000||£10,800|
|Higher Rate Band @ 40%||£57,000||£22,800|
Ellen will pay £8,800 less Income Tax and gain £4,400 within her pension following her contribution; she has effectively received 60% tax relief on her contribution!
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