I’m paying 60% tax on a £5,000 pay rise: Will topping up my pension help?

I got a £5,000 pay rise last summer which took my salary from £105,000 to £110,000 per year.

However, my income puts me in the position where my personal allowance is being removed, meaning that I am effectively paying 60 per cent tax on that pay rise.

This seems extremely unfair considering the top rate of tax for those earning much more than me is 45 per cent.

Until now this hasn’t really affected me too badly, as my employer runs our pension scheme through salary sacrifice and I pay in 5 per cent of my salary, which reduces my income by £5,250.

Now though I find myself losing the lion’s share of my pay rise. I have been told that if I make extra pension contributions to a self-invested personal pension, it would reduce my taxable earnings and could reinstate my personal allowance.

I have some savings that I could use to put £5,250 into a pension. Would this reduce my earnings back to £100,000 and get me out of this tax trap. Do I need to do it before the tax year ends?

Tanya Jefferies, of This is Money, replies: Many more people are going to be pushed into higher tax brackets as their salary increases over the next few years, and are likely to consider putting extra into their pensions to reduce their pay and therefore their tax burden.

The latest Office for Budget Responsibility projections issued with the March Budget showed that between 2021/22 and 2027/28 there would be 2.1million new higher rate taxpayers – an increase of 47 per cent from 4.6milllion to 6.7million.

There are also expected to be 350,000 new additional rate taxpayers in the same period – also an increase of 47 per cent, from 650,000 to 1.1million.

There is a round-up of the effects of new tax ‘cliff edges’ here,  and This is Money’s Editor Simon Lambert calls on the Chancellor to fix them here.

We asked a financial expert to explain what this will mean for you and others in your situation, and how to mitigate the impact by making extra contributions into your pension.

There isn’t long to take advantage of this in the current tax year, which ends next Wednesday, 5 April.

Richard Harwood:  Pensions are a very valuable investment given the tax-free growth and tax-free cash element but also in the ability to claim tax relief on contributions

Richard Harwood, financial planner at wealth manager RBC Brewin Dolphin, replies: Pensions are a very valuable investment given the tax-free growth and tax-free cash element but also in particular the ability to claim tax relief on pension contributions.

As you have identified, this is of most benefit for those who have income of just over £100,000 where they lose personal allowance.

The tax-free personal allowance reduces by £1 for every £2 your adjusted net income exceeds £100,000. It is actually nil once your income exceeds £125,140.

Although income that falls within the higher rate band is taxed at 40 per cent, the personal allowance taper means some of your income could effectively be taxed at a staggering 60 per cent.

In your situation, you have sensibly been paying 5 per cent of your salary into your employer’s pension scheme, reducing your income to £99,750 and keeping your personal allowance intact.

So, to understand your position following your new pay rise, your new £110,000 salary, which equates to £104,750 after your 5 per cent salary sacrifice, effectively means that you would now pay £1,900 tax on the £4,750 and you would also lose £2,375 of your personal allowance.

This extra £2,375 would also be taxed at 40%, costing you another £950. As a result, earning an extra £5,000 would increase your taxable income by £4,750 (after your existing pension contributions) costing you £3,325 in tax, which equates to a 60 per cent effective tax rate.

One way to mitigate the so-called ’60 per cent tax trap’ is to save into any form of pension.

If you made a gross pension contribution of £5,000, your adjusted net income would fall below £100,000, thereby reinstating your personal allowance and giving an effective rate of tax relief of 60 per cent on your pension contribution.

Of course these figures are based upon total annual income. If you are receiving a pay rise part way through a tax year, the difference would not be as great.

A £5,000 per annum pay rise in September, would mean that your annual income had risen by £2,500 over the tax year. So, you may only need to make a contribution of around that amount.

To make a difference in this tax year, you would need to make a contribution before 5 April to lower your income before the end of the tax year and if you have the available funds to make a pension contribution, it should certainly be worth doing so.

We have seen lots of pension policy changes recently and there is now a limit of £60,000 annual pension allowance, but you would be well below this, with the £5,250 salary sacrifice and the £2,500 Sipp contribution.

Also, I’m unsure of the value of your overall pension savings but here is now no current lifetime limit to the amount you can invest in a pension.

Pensions are complicated as your situation highlights and understanding the tax situation and the impact on your overall finances can be bewildering, and that’s where getting some smart advice can help.

In general, an adviser will take a thorough look at your financial situation and your income and determine what pension contributions suits your individual circumstances.

They can also help you select the right pension fund for your needs, advise on other tax-efficient forms of investing, and keep on top of any changes to pension rules.