Case Study: Avoiding the child benefit tax trap
James (33) and Tanya (28) have a son, Paul who is 3. James is an editor at his local newspaper and has a salary of £60,000 p.a.
Tanya looks after Paul and earns £6,000 p.a. working part time at a coffee shop. At the moment they receive Child Benefit of £20.70 p.w. (£1,076 p.a.) but since James’ adjusted net income is over £50,000 p.a. he will need to pay a tax charge calculated as 1% of the Child Benefit received per £100 his income is over £50,000. James’ adjusted net income is actually £10,000 higher than the threshold so the tax charge is equal to the amount they have received (£1,076, equivalent to 10.76%).
James & Tanya have two options:
- Stop claiming Child Benefit
- Reduce James’ adjusted net income
One way that James could reduce his adjusted net income to below £50,000 (and avoid the tax charge) would be to make a personal pension contribution. Tax relief at 20% (basic rate) is added to the contribution by the government so a payment of £8,000 net would be worth £10,000 in his pension. As a higher rate tax payer he can obtain a further 20% relief on the £10,000 gross contribution (£2,000).
James’ adjusted net income is reduced by the value of the gross pension contribution (£10,000) from £60,000 to £50,000. This means that he does not now have to pay the High Income Child Benefit Tax Charge.
If James does nothing he will have to pay a tax charge of £1,076.
If he makes a net contribution of £8,000 before the end of the tax year (5 April ) he will end up with:
- £10,000 in a pension growing free from most taxes
- £2,000 reduction in his income tax liability
- £1,076 reduction in other taxes.
Simply by doing this James has increased his wealth by £5,076 – a 63% return on his £8,000 net pension contribution.
N.B. This return only considers the initial tax benefits and does not consider the longer term benefits of making pension contributions. Couples with more than one child can potentially have an even greater tax trap.