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Tax traps to be aware of and how to beat them · On The Money

• 0:03
  Kyle Caldwell: Hello, and welcome to On The Money, a weekly show that aims to help you make the most out of your savings and investments. In this episode, we're gonna be discussing some of the biggest traps that are lurking in The UK tax system. And joining me to discuss this topic is Craig Rickman, who is personal finance editor at Interactive Investor. Craig, welcome back to the podcast.
• 0:28
  Craig Rickman: Thank you very much for having me on.
• 0:30
  Kyle Caldwell: Before we go into the topic, a little icebreaker, pub quiz question for you. What is 22,000 pages long? What is 22,000? I'll give you a clue. It is related to the episode.
• 0:42
  Craig Rickman: Alright. Is that the I don't know, The UK tax handbook?
• 0:46
  Kyle Caldwell: Yeah. I mean, essentially, it is. It's how long The UK tax code is Alright. Which is the longest tax code in the world. And as we're gonna be talking about, it is very complicated and this is the reason why some people can fall into these potential tax traps.
• 1:02
  Craig Rickman: Right. Okay. That's interesting. I didn't know that. I feel like I should, but I I didn't.
• 1:06
  Kyle Caldwell: So let's actually, before we go into the tax traps we're gonna focus on, firstly, could you define what a tax trap actually is?
• 1:15
  Craig Rickman: Sure. Yeah. I mean, tax tax traps are a are a huge topic at the moment. Yeah. But but to break down, you know, what it what a tax track means, so, essentially, there are quirks in The UK tax system where you can pay an unusually high effective rate of tax.
• 1:32
  So The UK tax system is set up on what's called a or constructed on what's called a progressive basis, meaning is meaning that as your earnings or your income rises, then the tax rates rise with them. So if we look at the the income tax system in England, Wales, Northern Ireland, you you pay no income tax on the first around 12 and a half thousand pounds. Between 12 and a half thousand pounds up to around £50,000 you pay 20%. 40% just above 50,000 up to just around sort of the £125,000 mark and then 45% or anything above so sort of they increase as your income increases. However, sort of lurking within the framework due to things like lost valuable allowances and and potential charges for for benefits that you might receive, the combination of that and the marginal rates you pay can create, you know, tax rates or effective tax rates of, you know, 50%, 60%, or perhaps even more on a portion of your income.
• 2:41
  So, you know, in some cases, due to some of these tax traps, you could even be worse off. And what we're seeing over time is that more people are falling into these traps, and a big reason for that is is something called fiscal drag, which is something else which is making a been making a lot of headlines in in the past few years, which is this economic phenomenon of of sort of frozen tax thresholds or tax rolls being frozen over time. And as people's incomes rise, then more of them are tripping sort of into higher rates of tax and tripping in to these tax traps.
• 3:18
  Kyle Caldwell: So let's unpack fiscal drag, which, as you just mentioned, is the main reason why more and more people are being pulled into tax traps. So we've had frozen personal tax thresholds since April 2021, and they're gonna stay frozen until 2031. The personal allowance has been frozen at 12,570 a year, and the higher rate threshold has been frozen at just over 50,050 thousand 270. In my view, fiscal drag is a very sneaky way to increase the tax burden over time. It results in people paying tax more on their income as their income rises in line with wages going up.
• 4:06
  And it's it's much less obvious than raising tax rates, and it makes wage increases become less meaningful.
• 4:15
  Craig Rickman: Well, absolutely that. And with sort of relevance to the tax traps, it means people can be pulled into them unwittingly. So as as you know, when their salaries rise, naturally rise over time in line with inflation, where they receive bonuses, or they receive income from other sources, if the tax thresholds are frozen, then, yeah, without them really knowing about it, they can get pulled into these really punishing tax rates with without realizing. So, yes, I mean, the the the impact of fiscal drag, you know, as you say, some of the or many of the tax thresholds have been frozen since the start of the decade, but there are other instances within the tax framework of fiscal drag sort of being around for a lot longer as well. So it's, yeah, it's become a bit of a feature of the tax system and, you know, it can be quite punishing for for a lot of people.
• 5:07
  Kyle Caldwell: And one tax shop that's been getting a lot of attention, particularly at the moment, is the one that kicks in when earnings exceeds a £100,000. This is dubbed either the 60% or 62 tax trap. And it's you know, you you think, actually, this is not gonna impact that many people, but it does. It's gonna impact around 2,000,000 people in the current tax year. Now those earning, you know, over a 100 k, they are in the top 5% of earners.
• 5:39
  However, the amount of tax being paid is punitive, and the £100,000 figure has not increased since the system was introduced in 2010. So, Craig, could you explain why, due to the way the tax system works, the people in that brackets are being hit with a 60% tax draw? Sure. Yeah. So once your earnings go above a £100,000,
• 6:07
  Craig Rickman: for every for every £2 that your income exceeds a £100,000, you lose one pound of your 12,570 personal allowance. So once your income reaches a 125,140, you lose your your your tax free allowance. The combination of that plus the 40% income tax you pay creates this 60% tax trap. Once you factor in National Insurance as well, which is paid at 2% on earnings in the or earnings above 50,270, it's a, yeah, it's a 62% or 62% tax rate, 62% tax trap. So, yeah, what that means is on that proportion of income, the government would take 62 p in every pound that you earn.
• 6:55
  So, you know, punitive stuff. So we're going back to your point around fiscal drag and the, you know, the 2,000,000 people who are expected to earn above a 100,000 this year. If we go back to when that system was introduced in 2010, the number was was was about just under 600,000. It was 588,000. So in the sixteen years, sixteen year period, you've seen four times as many people fall into this, you know, this this this this pretty nasty tax trap.
• 7:26
  So and as you know, tax thresholds are due to to remain frozen until 2031, so even more and more people, yeah, are gonna get pulled and pay, yeah, a really punishing raise of tax.
• 7:39
  Kyle Caldwell: And it's your taxable earnings, so that includes if you get a bonus. It's not just your base salary?
• 7:45
  Craig Rickman: That's right. Yeah. Well, it's called, yeah, adjusted net income or taxable income. But, yeah, you it's it's it's you you your total income. So that could be from salary, it could be from bonuses, it could be from interest that you receive in any savings accounts that exceeds your savings allowance.
• 8:05
  And if you're a higher rate taxpayer, you get a savings allowance of £500 a year, so anything that exceeds that will will go towards it. It could be dividends that you receive from shareholdings outside of tax wrappers. It could be property income. So yeah. So I think that's and that's one of the ways that people can get caught out because you may assume that it's just your salary and your bonus that that gets impacted by this this tax trap.
• 8:31
  But now it's all, no. It's it's essentially any any form of of taxable income that you have. For the earnings in that portion, the government is taking a bigger share of your income than you than you get. So it can it can be a bit of a a deterrent, but still at the same time, if someone's earning £99,000, they will have they'll they'll still have less money at the end of the month than someone who earns, say, 110,000, unless they are parents of young children. So that's that's, you know, that's one of the that's one of the particularly punishing areas of of the tax system.
• 9:10
  Kyle Caldwell: And the reason why is because if you earn a pound over a £100,000, then you lose out on potentially thousands of pounds in free childcare, and this particularly impacts those that have young children.
• 9:24
  Craig Rickman: Yeah. I mean, this is, you know, the the, you know, without a doubt, the most punishing tax trap or punishing aspects of of the tax system, and it's the main reason for that is like you say, it's, excuse me, it's a it's applied at a cliff edge rather than a tapering system like like applies to the 60% tax trap. So so yeah. So once earnings reach or exceed a £100,000 a year, you can lose free childcare. So you can lose tax free childcare.
• 9:54
  I mean, it's called tax free childcare. The it's that's a little bit misleading or very misleading. It works as more of a top up to to childcare so that for every pound you pay, the government could potentially pay up to to 20 p. That's worth £2,000 a year, so you would you would lose that if if earnings exceed a £100,000 plus you can lose free childcare hours. So parents of young children and and the ages of these these children or the ages where this child care applies to are those between nine months and four years up to up to five essentially.
• 10:31
  But but those could also get thirty hours of free child care, but that reduces down to fifteen hours. Yet if you earn a pound above a £100,000. So, yeah, the situation is that that families could be, you know, thousands of pounds worse off by earning just a pound more. In fact, a think tank crunched some numbers on this recently and found that that someone, if you took a fairly extreme example, would have to earn a $100,145,000 pounds a year to not be worse off. So you have this sort of, you know, bizarre situation where, you know, you could have, you know, someone earning £99,000.
• 11:11
  It'd be better off than someone else earning a 140 because of the way the the childcare system works, which is astonishing. And and, you know, not to mention deeply unfair. Another aspect of the unfairness is that it only applies to a to a sort of a single person's income. So essentially, you could have a household where you have two people working and they each earn £99,000 a year, they get to keep the the free childcare. You have another house household where one doesn't work, looks after the children, one one spouse or partner, and the other works and earns a £100,000 a year, so effectively half, and they lose the free childcare.
• 11:57
  So that's another punishing aspect of it. And so, yeah, there are lots of accusations of unfairness and, you know, they're they're difficult to disagree with. I mean, it's it's it seems, you know, frankly, quite ridiculous system.
• 12:08
  Kyle Caldwell: I completely agree. It's a it's a grossly unfair system. It's based on one person rather than based on the the wages of the household. On a more positive note, this is something that the education secretary has said they are looking at. They said that the £100,000 childcare cliff edge is under review.
• 12:29
  So, hopefully, we'll get some sensible reform in that area that no longer penalizes those that are impacted by that cliff edge. However, that's not the only tax trap that affects parents of young children. There's another lurking in the system at once earnings exceed £60,000, and this is called the high income child benefit charge. So this increases the effect of marginal tax rates for the parents with one, two, or three children to 49%, 5358%. Craig, could you talk us through it?
• 13:10
  Craig Rickman: I can indeed. So, if you are a parent of, children that are aged up to to age 16 or up to age 20 are in full time education, then you can claim child benefit. So the child benefit payments are for the first child, it's paid weekly, but you you get around £1,400 a year. And then for any subsequent children, you get around £930 a year. So for a household with two children, you can claim about £2,300 a year.
• 13:43
  So you know a valuable a valuable sort of source of household income. However, if one person of the household's earnings, when one person's of the household's earnings starts to exceed £60,000 then you can face a charge on child benefit. So and the charges for every £200 above, the charge is 1%. So what that means is once income hits £80,000, the charge equals the amount of child benefit. So it's completely wiped out.
• 14:16
  In a sort of a similar problem to the the childcare system applied at the 100 k cliff edge, it's based on one partner's income. So it's not a household income. So you could have a situation where you had two people each earning, you know, just under £60,000 a year within the household, so collectively a 120. They can still claim the child benefit payments or, sort of more accurately, they wouldn't face a charge on the the child benefit payments. Whereas if you had another household where someone was earning one person was earning £80,000, then they pay the the full charge wiping out the child benefit payments.
• 14:56
  So, again, it's another sort of punishing tax trap that that lurks in in the system that that can catch people out.
• 15:04
  Kyle Caldwell: It can make sense for some people earning £80,000 or more to apply for child benefits and then not receive it. Could you explain why?
• 15:15
  Craig Rickman: Yeah. Sure. Because that could be the temptation, couldn't it? You think, well, if I'm if I'm gonna pay this charge on the child benefit pay payments, then, you know, what's what's the point in claiming it? But there are still, you know, there's a really good reason to to claim it.
• 15:29
  And that's because by claiming child benefit, it counts towards your state pension record. So it's counts as a qualifying national insurance credit, and so it enables you to build up, you know, really valuable qualifying years for your for your state pension. So but as you note, can you can claim child benefit but opt out of the payments because the way that the child benefit charge is collected is is typically through a an adjustment to PAYE. So you you it's collected elsewhere through the tax system. But if you didn't want that to happen, then, yeah, you would say you wanna claim child benefit but opting out of the payments, and that means that you avoid so getting into the situation where you receive child benefit and then pay a charge, but it can also count towards your state pension record.
• 16:21
  Kyle Caldwell: So this will count towards your spouse's state pension record if they're not working, and you're in a position where you earn £80,000 or more?
• 16:30
  Craig Rickman: That's right. Yeah. So it's it's would be the the the essentially, the caregiver. So the the one who's looking after the children, the one who's out of work, that's the person to claim. Yeah.
• 16:39
  Absolutely right.
• 16:39
  Kyle Caldwell: The threshold for the high income child benefit charge, it used to be between £50,000 and £60,000. And when that change was made, the previous governments also proposed to make their system fairer by moving to a to a household income system by April. However, that's not happened. Labor scrapped those plans in its first budget as it thought that the change would be too expensive.
• 17:09
  Craig Rickman: Yes. That's a real shame that we've got a long way towards, you know, making this system fairer, which, you know, as as we've discussed, it's it really isn't fair in its current form, so that's a real shame. I think all we can do is is hope that the current government or a future government revisits revisits the problem. And, you know, especially if they're looking at the the the the the 100 k cliff edge for for free childcare, it would make sense to look at this look at this as well and address the unfairness within this part of the system.
• 17:44
  Kyle Caldwell: So how can people practically try and beat this big tax shop, the 100 k cliff edge. Is the first protocol looking at pensions and potentially making greater pension contributions,
• 17:58
  Craig Rickman: and that's gonna reduce your taxable earnings overall? Yeah. Well, pensions can be a really a really effective effective tool when when planning around tax traps. And that's because, as you've noted, pension contributions can reduce your, what's called, net adjusted or taxable income. The the thing to to sort of consider there is that when you're putting money into a pension for this purpose is that you can't get your hands on that money until age 55, and that's rising to 57 in 2028.
• 18:36
  So it's really important to bear that in mind, but provided you're happy to lose access to the money, and for some people, might be short on their retirement savings anyway, so it can sort of help solve that problem. But paying into a pension can be a really good way, yeah, to avoid the trap. So let's look at a sort of basic example. So let's say you earned a £110,000 a year. If you added if you pay £10,000 personally into your pension that year and I say personally, it could be through your employer as well, and you can reduce your income down to below a £100,000, then you can potentially avoid the the the tax trap at 6060% or 62% plus keep, you know, the the valuable free childcare as well.
• 19:24
  So so in some cases, by paying into a pension, you can actually be better off. And so there's there's a couple of ways that you can go about it. So if you're employed and your employer offers salary sacrifice, then you can just reduce your income below a £100,000. So so salary sacrifice works where you you trade a portion of your income for an equivalent pension payment. So in that scenario, it could be instead of receiving a £110,000 a year salary, you reduce it down to a £100,000, hence swerving the tax trap, potentially keeping free childcare.
• 19:58
  What we should note is that not everyone is employed and has access, and even those who are have have access to salary sacrifice. So the other way you can do it is to make personal pension contributions to something like an interactive investor SIP. So in that scenario, let's say you wanted to make a contribution of £10,000, you pay £8,000. That's topped up by £2,000 by the government with basic rate tax relief. And so then that can reduce your net adjusted income by that amount.
• 20:30
  If you are using the latter and you're making personal contributions, the really important thing to do is to make sure that you put it on your tax return. So even though you're making pension contributions, you need to be able to sort of tell the tax authorities that that's what you've done. So but, yeah, pensions, as long as you're sort of happy to tie the money up into retirement can be a, you know, a wonderful tool to help beat the tax traps. And, you know, particularly around the free childcare cliff edge, you could end up being better off as a result.
• 21:03
  Kyle Caldwell: So as you just explained, Craig, upping your pension contributions is pretty much the main way to try and stay below that £100,000 threshold if it makes sense for you to do so. However, another way is to give away some of your money to charity through gift aid as this reduces your overall taxable income.
• 21:26
  Craig Rickman: That's right. Yeah. So if you've got any, you know, causes that you'd like to support and you and you're feeling generous towards those, then, yes, you know, making donations to a charity could also reduce your taxable income. In the same vein as as making personal pension contributions, again, that's something that you would need to to place on your on your tax return. But, yeah, it can be a yeah.
• 21:50
  Yeah. A an effective way to reduce your taxable income.
• 21:53
  Kyle Caldwell: So while that is another way to go about trying to beat this 100 tax trap, the main one, as you've covered, is if you can to increase pension contributions, whether that be into a workplace pension or into a self invested personal pension, a SIP. And those that are that are earning between a 100,000 and a £125,000 and are caught out by the 100 k tax trap, they can put up to £60,000 a year into a pension.
• 22:22
  Craig Rickman: That's right. Yeah. Yeah. Most people, you can put, yeah, up to £60,000 a year or a 100% of what you earn, whichever those is lower into a pension and get tax relief at your marginal rate.
• 22:34
  Kyle Caldwell: Well, Craig, I think you've provided plenty of food for force for those that are potentially impacted by some of the biggest traps in our UK tax system. Thanks for coming on.
• 22:47
  Craig Rickman: Thank you very much for having me.
• 22:49
  Kyle Caldwell: And thank you for listening to this episode of our On The Money podcast. We love to hear from listeners, and the way to get in touch is by emailing otm@ii.co.uk, and we love to hear from you if you have an interesting idea that you'd like us to cover on the podcast or you have a question that you would like myself or one of the team to tackle in a future episode. In the meantime, you can find plenty of analysis related to personal finance and investments on the Interact Investor website, which is ii.co.uk, and I'll hopefully see you again next Thursday.