The 60 percent tax trap: what is it?

You might be caught in the 60% tax trap if your income exceeds £100,000

What is it, and how can you stay away from it?

While receiving a pay increase might seem like a cause for celebration, for some high earners, it means that your income will be subject to ever-higher taxes.

The acronym "HENRY," which stands for "High Earner, Not Rich Yet," is becoming more and more popular among members of this demographic.

It alludes to the fact that, under UK tax law, earning more than 50,271 is taxed at 40 percent, while earnings over 125,140 are taxed at 45 percent. This means that being a high earner also tends to mean you are subject to a high marginal income tax rate.

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Start your trial, but there is another hidden tax rate in the UK that only applies to people who make between £100,000 and £125,140 due to a peculiarity of the tax system.

As the 12,570 tax-free personal allowance tapers off once you surpass 100,000, these earners may be subject to what is essentially a 60 percent tax rate on a portion of their income.

According to HMRC projections obtained by wealth manager Rathbones, approximately 2.06 million taxpayers, or roughly 6% of the entire UK workforce, are expected to fall into the 60% tax trap in the 2026 - 2027 tax year.

We describe the 60 percent tax trap and show you how to avoid the worst of it.

The 60 percent tax trap: what is it?

In the UK, there are four primary tax bands for income tax, plus a fifth that is hidden.

The first is your personal allowance, which means that if you make less than £100,000 in a tax year, you are exempt from paying any taxes on the first £12,570.

The basic income tax rate is the second. You will pay 20% in this band if your income falls between £12,570 and £50,270. For the majority of British citizens, this will be their highest income tax.

Income between £50,271 and £125,140 is subject to a 40 percent income tax rate.

Additionally, if your income exceeds £125,140, you will be subject to a 45 percent additional rate of income tax.

However, once you start making more than £100,000, a peculiarity in the UK tax system means that you are subject to an effective 60% tax rate.

Your tax-free personal allowance begins to decrease at a rate of one for every two dollars you make over £100,000 after you reach this threshold. When you hit the 125,140 additional rate tax threshold, it completely vanishes.

This means that for every £100 earned between £100,000 and £125,140, 40 is withheld in income tax, and an additional £20 is lost due to the loss of your personal allowance. That corresponds to a 60 percent marginal tax rate in real terms.

Since you will have lost all of your personal allowance by then, the effective tax rate on your earnings above 125,140 then goes back to 45%.

Additionally, some people will no longer be eligible for certain government programs if their income exceeds £100,000.

For instance, you automatically lose access to free childcare hours, which are worth up to 2,000 per child annually, the moment you make more than £100,000.

You will completely lose Child Benefit through the High Income Child Benefit Charge (HICBC) if your individual income is 80,000 or more. Once your individual income surpasses 60,000, you will have to begin repaying a portion of it.

How to stay out of the 60% tax trap.

You must lower your taxable income in order to escape the 60 percent tax trap.

This does not imply that you should turn down a potential pay increase or accept a pay reduction. Rather, there are acceptable methods for lowering your take-home pay without sacrificing your earnings.

To avoid the 60% tax cliff-edge, you are essentially attempting to reduce your take-home pay to less than £100,000.

Increasing your pension contributions through salary sacrifice is one way to achieve this.

Up to an annual cap of 60,000 (or 10,000 if you make more than 200,000), the government offers tax relief on your pension contributions, so you don't have to pay taxes on the money you contribute.

This increases your pension fund and helps you avoid the marginal 60 percent tax rate between £100,000 and £125,140 by lowering your taxable income.

There are other salary sacrifice plans that you might think about. These might include things like the Cycle-to-Work program or using salary sacrifice to lease an electric vehicle.

Another option is to use Gift Aid to make a charitable donation. By doing this, you can avoid a tax cliff-edge and support organizations that are doing good in the world by lowering your taxable income in a manner similar to salary sacrifice.