What Is the 60% Tax Trap and Who Does It Affect?

Introduction

The UK tax system is known for its complexity, with various thresholds and allowances sometimes leading to unexpectedly high marginal tax rates. One such quirk is the "60% tax trap," a situation where taxpayers face an effective 60% tax rate on certain portions of their income. This article explores the mechanics of this tax trap, who it affects, and strategies to mitigate its impact.

Understanding the 60% Tax Trap

The 60% tax trap occurs because of the tapering of the personal allowance for individuals with incomes over £100,000. The personal allowance is the amount of income one can earn tax-free each year, set at £12,570 for the 2024/25 tax year.

When income exceeds £100,000, the personal allowance is reduced by £1 for every £2 over this threshold. By the time income reaches £125,140, the personal allowance is entirely withdrawn. This means income between £100,000 and £125,140 is effectively taxed at 60%, combining the 40% higher rate of income tax with the allowance reduction.

Historical Context

The tapering of the personal allowance began in the 2010/11 tax year to increase tax revenues from higher earners. Initially, it applied with an upper limit of £112,950. With the increasing personal allowance, the upper limit rose, extending from £100,000 to £125,140 in the 2024/25 tax year.

Who Is Affected?

The 60% tax trap primarily impacts individuals with adjusted net incomes between £100,000 and £125,140, including:

• High-earning professionals: Doctors, lawyers, and senior executives.
• Small business owners: Those drawing incomes within this bracket.
• Dual-income households: Combined incomes pushing a partner into this range.

In the 2023/24 tax year, about 634,000 taxpayers were affected, a 45% increase from 2021/22. This surge results from wage inflation and frozen tax thresholds, known as "fiscal drag."

The Impact of Fiscal Drag

Fiscal drag occurs when tax thresholds and allowances remain unchanged despite inflation or wage growth, pushing more earners into higher tax brackets. The personal allowance has been frozen at £12,570 since April 2021 and will remain so until 2028. This freeze, alongside rising incomes, inadvertently catches more taxpayers in the 60% trap.

Additional Consequences: The Childcare Benefit Cliff Edge

Beyond the loss of the personal allowance, individuals earning over £100,000 also lose eligibility for government-funded childcare. The UK offers 30 hours of free childcare per week for working families with children under three, withdrawn entirely if a parent's income exceeds £100,000. This "childcare cliff edge" can create a marginal tax rate exceeding 100% for some families.

Strategies to Mitigate the 60% Tax Trap

While challenging, there are strategies to reduce the trap's impact:

1. Pension Contributions

Additional pension contributions can lower adjusted net income. Contributions receive tax relief at the highest marginal rate, reducing taxable income and preserving the personal allowance. More on how to manage your UK pension contributions can be found here.

2. Charitable Donations

Gift Aid donations reduce adjusted net income. The gross donation value (donation plus basic rate tax relief) is deducted from income, helping retain the personal allowance. For further details on charitable contributions, refer to this article on tax-efficient philanthropy.

3. Salary Sacrifice Schemes

Salary sacrifice arrangements, like exchanging salary for non-cash benefits, can lower taxable income. Care is needed to ensure other entitlements aren't affected, such as state pension contributions. Learn more about the effects of salary sacrifice schemes in this guide here.

4. Spousal Income Redistribution

For married couples or civil partners, redistributing income between partners can be beneficial. If one partner is below the £100,000 threshold, transferring income-generating assets can help mitigate tax impacts.

The Broader Economic Implications

The 60% tax trap has broader implications beyond individual taxpayers. It can deter career progression, overtime, or accepting bonuses, as additional income attracts disproportionate taxation. This disincentive could affect productivity and economic growth as individuals limit earnings to avoid the trap.

Government's Stance and Future Outlook

The UK government continues the freeze on the personal allowance until 2028, likely increasing those affected by the 60% tax trap. Despite discussions and critiques about fairness and economic impact, no immediate changes are planned.

Navigating the Tax Maze

Understanding UK tax system nuances, particularly the 60% tax trap, is crucial for effective financial planning. By recognizing thresholds and implementing strategic measures, individuals can mitigate this tax anomaly's effects. Consulting a tax professional can provide tailored strategies, ensuring efficient navigation of the tax system.