Originally published at: Avoid the 60% tax trap: How SIPP or pension contributions can save tax – InvestEngine Insights
Did you know that some UK taxpayers face an effective income tax rate of 60%? This is often referred to as the “60% tax trap”. It happens when your income reaches the threshold where your personal allowance is withdrawn.
However, with careful financial planning and the right use of a personal pension or a Self-Invested Personal Pension (SIPP), you can sidestep this high tax rate. Here’s how it works and what you can do about it.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.
What is the 60% tax trap?
The 60% tax trap occurs when your income exceeds £100,000. For every £2 of income above this threshold, you lose £1 of your personal allowance.
The withdrawal of the personal allowance effectively creates a 60% marginal tax rate for income between £100,000 and £125,140. Once your income reaches £125,140, you lose your entire personal allowance.
Say you earn £110,000 – that’s £10,000 over the £100,000 threshold where your personal allowance starts to taper.
You’d pay 40% tax on that extra £10,000, which comes to £4,000. But you’d also lose £5,000 of your tax-free personal allowance, meaning another £5,000 of your income would now be taxed at 40% too – costing you another £2,000.
So altogether, you’d pay £6,000 in tax on that £10,000, leaving you with just £4,000. That’s an effective tax rate of 60%.
How a personal pension or SIPP can help
One of the most effective ways to avoid the 60% tax trap is by contributing to a pension.
Whether it’s a traditional personal pension or a Self Invested Personal Pension (SIPP), your contributions can reduce your taxable income. This can help you bring your income back below the £100,000 threshold and preserve your personal allowance.
For example:
- If your income is £110,000 and you contribute £10,000 to a SIPP or personal pension, your taxable income falls to £100,000.
- This means you retain your full personal allowance and avoid the 60% tax trap.
The mechanics of tax relief on pension contributions
When you contribute to a personal pension or SIPP, you receive tax relief at your marginal rate:
- Basic-rate taxpayers receive 20% relief automatically
- Higher-rate taxpayers can claim an additional 20% through their self-assessment tax return
- Additional-rate taxpayers can claim up to 25% in extra relief.
For higher and additional-rate taxpayers, this tax relief makes pension contributions particularly advantageous, effectively reducing the cost of saving for retirement.
If you contribute to your pension through your employer, they typically apply basic-rate tax relief automatically through the payroll. However, if you pay higher or additional-rate tax, you may need to claim the extra relief yourself via a self-assessment tax return or through HMRC’s online service.
This ensures you receive the full tax benefit to which you’re entitled. If you don’t usually complete a self-assessment return, you can contact HMRC to request a tax code adjustment so the extra relief can be applied to your PAYE income in future.
You can also use our tax relief calculator to find out how much you could be entitled to.
Maximising your pension contributions
If you’re looking to avoid the 60% tax trap, consider the following strategies:
1. Use your annual allowance
You can contribute up to £60,000 per year to your pension (or 100% of your earnings, whichever is lower) and receive tax relief. However, if you have already accessed your pension, the annual allowance may be reduced to £10,000 under the money purchase annual allowance (MPAA).
2. Carry forward unused allowances
If you haven’t used your full annual allowance in the past three tax years, you can carry it forward to increase your current year’s limit. This is a valuable tool for higher earners who want to make larger contributions.
3. Align contributions with bonuses or other income
If you receive a bonus or other irregular income, consider using it to make a lump sum pension or SIPP contribution. This can help you manage your taxable income and preserve your personal allowance.
Additional considerations
The lifetime allowance
Although the lifetime allowance (the maximum you can hold in pensions without incurring additional tax) was previously a concern for high earners, it has been abolished as of the 2023/24 tax year. This means there’s no longer a cap on the amount you can save in pensions over your lifetime without tax penalties.
Salary sacrifice
If your employer offers salary sacrifice, you can use it to make pension contributions directly from your gross salary. This reduces your taxable income and can also lower your National Insurance contributions.
Self-employed considerations
If you’re self-employed, you won’t have access to salary sacrifice, but you can still make personal pension or SIPP contributions and claim tax relief through your self-assessment tax return.
Investing in a SIPP, such as the one offered by InvestEngine, provides flexibility and control over your investments.
The impact of pensions on other benefits
Reducing your taxable income through pension contributions can also help you qualify for other benefits or tax reductions, such as:
- Child benefit: If your income falls below £50,000, you avoid the High Income Child Benefit Tax Charge.
- Student loan repayments: Lowering your income can reduce your monthly repayments if you’re on a plan that calculates payments based on income.
Why start now?
Planning ahead is crucial when it comes to pensions and taxes. By taking action now, you can:
- Avoid unnecessary tax bills.
- Maximise your retirement savings.
- Benefit from compound growth over time.
If you’re unsure about the best approach, consider speaking to a financial adviser or using an online pension calculator, like our tax relief calculator, to work out the impact of your contributions.
How InvestEngine can help
InvestEngine offers a account fee free, flexible SIPP that allows you to take control of your retirement savings (ETF costs apply). Whether you’re a seasoned investor or just starting out, our platform makes it easy to build a diversified pension portfolio tailored to your needs. With InvestEngine, you can:
- Choose from a range of investment options.
- Benefit from tax-efficient savings.
- Manage your pension online, anytime.
Avoiding the 60% tax trap is just one of the many advantages of proactive pension planning. By making smart contributions now, you can secure your financial future while keeping more of your hard-earned money today.
Capital at risk.
Frequently asked questions
What is the 60% tax trap?
The 60% tax trap occurs when your income exceeds £100,000, leading to a withdrawal of your personal allowance and an effective tax rate of 60% on income between £100,000 and £125,140.
How do pensions and SIPPs help reduce tax?
Pension and SIPP contributions lower your taxable income, helping you avoid the 60% tax trap while also qualifying for tax relief at your marginal rate. Our tax relief calculator can help you calculate what you could be entitled to claim.
What is a Self Invested Personal Pension (SIPP)?
A SIPP is a type of personal pension that gives you control over how your retirement savings are invested, offering flexibility and potential for growth. It’s ideal for those who want to choose their own funds or ETFs.
Final thoughts
The 60% tax trap is a significant burden for many UK taxpayers, but it’s not insurmountable. With careful planning and the use of a personal pension or SIPP, you can reduce your taxable income, retain your personal allowance, and build a more secure retirement.
For more insights and tools to help you make the most of your investments, there’s lots more on the InvestEngine blog – or have a look at our Education Series on YouTube.
There’s also a handy checklist to help you navigate the end of the tax year.
Important information
Capital at risk. The value of your portfolio with InvestEngine can go down as well as up and you may get back less than you invest. ETF costs also apply.
This communication is provided for general information only and should not be construed as advice. If in doubt you may wish to consult a professional adviser for guidance.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.