A growing number of high-income individuals are opting to reduce their net pay as a strategy to evade steep tax penalties, recent data indicates.

This trend arises because earning over £100,000 results in the gradual loss of the £12,570 annual tax-free personal allowance. Additionally, parents face cutbacks in their eligibility for free childcare. In certain situations, peculiarities within the tax framework mean that a parent of two who receives a salary increase may face an astonishing effective tax rate of nearly 600% on the income bracket between £100,000 and £102,000, as revealed by an analysis conducted by the investment platform AJ Bell. This rate is a staggering 13 times higher than the top income tax rate of 45%.

Data from HM Revenue & Customs, obtained by Times Radio, illustrates that an increasing number of workers are taking measures to navigate this tax dilemma. The population of those earning between £97,000 and £100,000 annually has surged nearly 20% from 87,000 in 2019 to 104,000 by 2022.

Between April 2019 and April 2022, the average wage growth was around 4% per year, implying that an individual earning £97,000 in 2019 might see their earnings reach approximately £109,000 three years later.

Similarly, individuals with salaries between £47,000 and £50,000, just beneath the £50,270 threshold for the 40% higher rate of income tax, grew by nearly 13%, increasing from 793,000 to 893,000 in the same timeframe.

During these years, parents with annual earnings exceeding £50,000 began to lose eligibility for child benefit (now valued at over £2,200 per year for two children), although the threshold was elevated to £60,000 last April.

Implications of the Situation

Myron Jobson from Interactive Investor pointed out that the clustering of salaries close to the tax cliff indicates that many workers are opting to forego additional income.

“Some individuals, when possible, are choosing salary sacrifice arrangements, wherein they request their employers to direct more funds towards their pension rather than inflating their taxable income,” he explained. “This is just one method to contribute to pensions while minimizing taxable income, and it may provide tax benefits for both employers and employees.”

Charlene Young from AJ Bell noted, “Those negotiating a salary exchange understand that it’s an effective strategy for reclaiming various tax allowances and benefits while simultaneously enhancing their retirement pot. It can effectively help evade some of the most complex tax traps.”

The mechanism of salary sacrifice involves reducing one’s income, consequently lowering tax and national insurance contributions. It also lessens the national insurance burden for employers regarding their workers’ salaries, but not for the funds directed into workplace pensions.

With the rate of employer national insurance contributions set to rise in April, this provides a stronger incentive for companies to offer salary sacrifice arrangements without necessarily decreasing overall pay for employees.

Rick Kelsey, a radio presenter residing near Alexandra Palace in London with his wife Chantal and their children, Albert and Elizabeth, is one of those benefiting from this strategy. Kelsey attempts to maintain his income beneath the £100,000 mark by contributing more to his pension, estimating that exceeding this threshold could result in rather costly ramifications regarding child support, potentially losing out on £13,000 this year.

He remarked, “I refer to £100,000 as a punishment threshold for income since, for countless ordinary working people, it makes working toward higher income seem pointless. While the argument that earning £100,000 enables higher childcare expenses is reasonable, a tax system that deters productivity and tax revenue creation is unacceptable.”

Understanding the Tax Cliff

Under current rules, individuals lose £1 of their tax-free personal allowance for every £2 they earn beyond £100,000, meaning that at £125,140, they forfeit the entire allowance of £12,570.

HMRC calculates tax liabilities using what it terms “adjusted net income,” which encompasses salaries, income from investments, cash, and property, but excludes pension contributions.

Those earning between £100,000 and £125,140 face a tax burden of 40% plus 2% national insurance on income exceeding £50,270. When factoring in the loss of personal allowance, these individuals effectively pay 62% tax on each additional £2 of adjusted net income earned beyond the £100,000 mark.

Young families are particularly affected, facing multiple benefits including tax-free childcare and child benefits. While many working couples can access all three benefits, high earners often receive minimal support.

Once a single parent’s adjusted net income exceeds £100,000, the family becomes ineligible for tax-free childcare— a government program that matches every £8 contributed with an additional £2 for nursery payments and related expenses. This assistance can reach up to £2,000 annually per child.

Additionally, higher-income parents lose access to 15 hours of free childcare weekly for children aged nine months and older in term time. For three- and four-year-old children, the benefit is limited to 15 hours instead of the anticipated 30.

Starting in September, children aged nine months will qualify for 30 hours of free childcare weekly during term time, yet families exceeding the £100,000 threshold will still miss out.

Child benefit provides £25.60 weekly for the first child and £16.95 for each subsequent child. For every £200 of adjusted net income one parent earns over £60,000, families forfeit 1% of the benefit. Consequently, once a household’s income reaches £80,000, the benefit disappears. Families can recover any overpayments through tax returns if they don’t opt-out of receiving these payments.

Understanding the Figures

The tax cliff can be exceedingly severe. For instance, if a parent with one child aged two and another at nine months earns £99,000 in adjusted net income but subsequently receives a £2,000 raise, tipping their income to £101,000, they could incur nearly £10,000 in losses, resulting in a staggering marginal tax rate around 600%, according to AJ Bell.

This figure includes a £400 deduction from their personal income allowance; £4,000 from tax-free childcare; £3,285 for losing 15 free childcare hours for the two-year-old and an additional £3,444 for the nine-month-old. Furthermore, they will owe an additional £800 in income tax, resulting in a £2,000 pay rise costing them £11,940— an effective marginal tax rate of 597%.

How to Navigate the Tax Trap

Currently, only about half of employers offer salary sacrifice options, though this could evolve following the anticipated increase in employer national insurance contributions come April.

The savings realized depend on the amount of salary exchanged and the taxpayer’s level. For example, an individual earning £45,000 annually will owe 20% income tax on earnings above the personal allowance of £12,570, totaling £6,486 in tax liability. Additionally, they would incur £2,594 in national insurance contributions, granting a net income around £35,920.

If that employee designated 5% of their salary to a workplace pension (the auto-enrollment minimum), amounting to £1,800, the tax relief at a 20% rate would raise the pension contribution to £2,250. Consequently, their take-home pay (after taxes and pension deductions) would be about £34,120, as per AJ Bell’s calculations.

Meanwhile, their employer would account for the £45,000 salary plus £6,000 in national insurance (calculated at a higher 15% rate, applicable from April), culminating in a total expenditure of £51,000.

If instead, the individual requested that £2,500 of their income be deposited into their pension through salary sacrifice, their salary would decline to £42,500. This adjustment would reduce their income tax by £500 (now £5,986) and national insurance by £200 (now £2,394), maintaining the net pay of £34,120 but increasing the pension contribution by £250 annually.

Consequently, the employer would spend £5,625 in national insurance on the new salary, plus the £2,500 contributed to the pension, settling at £50,625— a savings of £375.

Employees are encouraged to check with their employers about the availability of salary sacrifice schemes. Pension contributions made this way should be reflected on payslips, typically listed under a section for salary sacrifice or its equivalent.

However, Young advises caution: “If you consider salary exchange, be aware of two critical factors. It represents a contractual change, so you generally can only revisit it once annually during a designated period. Additionally, it effectively reduces your income, which may impact the maximum amount you can borrow for a mortgage or other employment-linked benefits.”

What are your thoughts? Should individuals earning over £100,000 maintain their tax-free personal allowance? Share your opinions in the comments below.