The £100k earnings tax trap
For many individuals, earning a six-figure salary is a milestone in their career but the achievement may not necessarily be reflected in their take-home income due to an effective tax rate of 60%, commonly referred to as the £100K tax trap.
What is the £100k tax trap?
UK resident individuals (and some non-UK residents) receive a tax-free personal allowance of £12,570 to set against their net income for a tax year. Net income is total income reduced by certain types of losses and deductible payments.
The allowance is reduced by £1 for every £2 of ‘adjusted net income’ which exceeds £100,000. This means that individuals with adjusted net income of £125,140 or more do not receive a personal allowance. Adjusted net income is income reduced, most commonly, by gross charitable donations under Gift Aid and personal pension contributions.
The restriction to the personal allowance has a significant impact on individuals with adjusted net income between £100,000 and £125,140. They suffer an effective income tax rate of 60% (62% including employee class 1 national insurance contributions) and fall into said £100K tax trap.
The £100k tax trap – an illustration
The current rates of income tax in England, Wales and Northern Ireland (on non-savings income) are as follows:
If an individual in England who earns a salary of £100,000 receives a bonus of £10,000, they will be liable for additional income tax of £4,000 at their marginal rate of 40%. They will also lose £5,000 of their personal allowance which will essentially turn £5,000 of tax-free income into £5,000 of income taxable at the higher rate of 40%. This results in additional income tax of £2,000.
So, the bonus of £10,000 creates a tax liability of £6,000 and an effective income tax rate of 60% on that bonus (62% including employee class 1 national insurance contributions). If the same individual earned a higher salary of £400,000, they would be liable for income tax of £4,500 on their bonus of £10,000 at their marginal rate of 45% (47% including employee class 1 national insurance contributions).
For individuals living in Scotland, the effective tax rate is currently higher on earned income in this earned income bracket at 67.5%.
Aside from the high effective tax rate, there are also implications for entitlement to government support for childcare costs
How to prevent the £100k tax trap
There are various strategies to preserve entitlement to the personal allowance for those affected by this issue.
Salary sacrifice
Salary sacrifice arrangements allow an employee to exchange some of their salary for benefits such as employer pension contributions, childcare vouchers and electric car lease schemes. The employee’s gross pay is reduced by the value of the benefit which in turn reduces the income tax and class 1 national insurance contributions for the employee and their employer.
These arrangements can be incredibly tax-efficient but care should be taken, as there are often also non-tax considerations e.g., level of income for benefits which depend on their rate of pay (for example, maternity/paternity leave) and their borrowing capacity in mortgage applications.
Charitable donations
Charitable donations are made net of the basic rate of income tax. For example, if an individual makes a charitable donation of £800 under Gift Aid, this would be grossed up to £1,000 for the basic rate of income tax which would be claimed by the charity from HMRC.
The individual’s basic and higher rate bands would be extended by the gross charitable donation of £1,000 which would reduce the amount of income taxed at 40% and 45%. The gross charitable donation would also be allowed as a deduction in the calculation of the individual’s adjusted net income which would restore some or all their personal allowance.
Personal pension contributions
Tax relief for contributions to a personal pension scheme is given in a similar way to charitable donations under Gift Aid. A contribution of £800 would be grossed up to £1,000 for the basic rate of income tax which would be claimed by the pension scheme administrators from HMRC.
Higher and additional rate tax relief would be given via the extension of the individual’s basic and higher rate bands for the gross pension contribution of £1,000. The gross pension contribution would also be allowed as a deduction in the calculation of the individual’s adjusted net income which would restore some or all their personal allowance.
How Moore Kingston Smith can help
If you fall within the £100k tax trap, depending on your circumstances, there are options to reinstate your personal allowance and reduce your effective rate of tax.
If you are an employer and looking at ways to help your employees navigate this, the Moore Kingston Smith Employee Benefits team can help you implement a compliant salary sacrifice arrangement.
If you require advice, please contact a member of our private client tax team.
