I pay 60% tax on a £5,000 raise: will increasing my pension help?

Last summer I got a £5,000 raise, taking my salary from £105,000 to £110,000 a year.

However, my income allows me to have my personal allowance removed, which means I effectively pay 60 percent tax on that raise.

This seems grossly unfair considering the top tax rate for those who earn much more than me is 45 percent.

So far it hasn’t affected me too much as my employer runs our pension scheme through pay cuts and I pay 5 per cent of my pay which reduces my income by £5,250.

But now I’m losing the lion’s share of my raise. I was told that if I made additional pension contributions to a self-invested personal pension, it would reduce my taxable income and my personal allowance could be restored.

I have some savings that could put £5,250 towards a pension. Would this reduce my income to £100,000 and get me out of this tax trap? Do I have to do this before the end of the tax year?

This is Money’s Tanya Jefferies responds: Many more people will be pushed into higher tax brackets over the next few years as wages rise, and will likely consider investing more in their pensions to reduce their wages and thus their tax burden.

The Office for Budget Responsibility’s latest projections, released with the March budget, showed that between 2021/22 and 2027/28 there would be 2.1 million new taxpayers with higher tax rates – a 47 percent increase from 4, 6 million to 6.7 million.

There are also expected to be 350,000 new additional taxpayers over the same period – also up 47 percent from 650,000 to 1.1 million.

There is a summary of the implications of new tax cliff edges here, and Simon Lambert, editor of This is Money, urges the Chancellor to fix them here.

We asked a financial expert to explain what this means for you and others in your situation, and how you can mitigate the impact by making additional contributions to your pension.

This can no longer be used for much longer in the current tax year, which ends next Wednesday, April 5th.

Richard Harwood, financial planner at wealth manager RBC Brewin Dolphin, responds: Pensions are a very valuable investment because of the tax-free growth and the tax-free cash element, but especially the possibility of claiming pension contributions for tax purposes.

As you’ve discovered, this is of greatest benefit to those earning just over £100,000 at which point they lose the personal allowance.

The non-taxable personal allowance decreases by £1 for every £2 that your net adjusted income exceeds £100,000. It is actually zero once your income exceeds £125,140.

Although income that falls in the higher tax bracket is taxed at 40 percent, the reduction in personal allowance means some of your income could effectively be taxed at a staggering 60 percent.

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

To understand your position after your new raise, your new salary of £110,000, which is £104,750 after your 5% pay cut, effectively means you would now pay £1,900 in tax on the £4,750 and would also lose £2,375 of your personal allowance.

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

One way to mitigate the so-called “60 percent tax trap” is to save for any form of pension.

If you made a gross pension contribution of £5,000 your net adjusted income would fall below £100,000 which would restore your personal allowance and give you an effective tax credit rate of 60% on your pension contribution.

Of course, these numbers are based on total annual income. If you get a raise during a tax year, the difference wouldn’t be that big.

A pay increase of £5,000 a year in September would mean your annual income would have increased by £2,500 over the tax year. So you only have to make a contribution of about this amount.

To make a difference this tax year you would need to make a contribution before April 5th to reduce your income before the end of the tax year and if you have the funds available to make a pension contribution it certainly should worth .

We’ve seen a lot of changes in pension policy lately and there’s now a limit of £60,000 a year in pension supplements, but you’d be well below that, with the £5,250 salary drop and the £2,500 Sipp contribution.

Also, I’m not sure about the value of your total retirement savings, but there is no current lifetime limit on the amount you can invest in a pension right now.

Pensions are complicated as your situation becomes clear and understanding the tax situation and how it will affect your overall finances can be confusing and this is where some wise advice can help.

As a rule, an adviser will carefully examine your financial situation and income and determine which pension contributions suit your individual circumstances.

They’ll also help you choose the right pension fund for your needs, advise you on other tax-efficient forms of investment, and keep you up to date on changes in pension rules.