Tax traps: what you need to know and how to avoid them

The tax landscape is littered with tax traps.

Several arise when your income crosses certain thresholds. Once you pass them, the consequences can extend beyond simply paying more tax on the next pound of income. You may start to lose allowances, benefits and even pension tax advantages, leaving you significantly worse off.

At Continuum we are pointing out some of the traps, and what you can do to help avoid them.

The 60% tax trap

Everyone is entitled to a personal allowance, meaning the first £12,570 of income is generally free from Income Tax. However, where adjusted net income exceeds £100,000, the personal allowance is reduced by £1 for every £2 of additional income, until it is fully withdrawn once income reaches £125,140.

As a result, individuals with income between £100,000 and £125,140 may face an effective marginal Income Tax rate of up to 60%.

This is because they pay higher-rate Income Tax on additional earnings while simultaneously losing part of their personal allowance. Once the personal allowance has been fully withdrawn, the effective marginal rate reduces to the taxpayer’s normal marginal tax rate, which may be 40% or 45% depending on their level of income.

In addition, parents in England with income exceeding £100,000 may lose eligibility for tax-free childcare support, which can further increase the overall financial impact.

It’s not just salary that pushes you into the trap. Bonuses, taxable dividends, savings interest, rental income and other taxable investment returns can all increase adjusted net income and potentially push an individual into this range

A pension contribution or Gift Aid donation can help bring your income back below the threshold.

The frozen tax trap

Tax thresholds used to rise a little each year to keep pace with prices. That stopped in 2021, with the personal allowance frozen at £12,570 and higher-rate Income Tax generally applying to taxable income above £50,270. The Autumn Budget last year extended the freeze to April 2031.

So, when wages rise, more of your income falls into higher rate tax. This effect is known as fiscal drag – or more vividly as stealth tax.

Putting more of your income into your pension in a process known as salary sacrifice might help keep you below a tax threshold.

The tapered pension tax trap

There is a cap (known as the Annual Allowance) on how much you can put into your pensions each year and still receive tax relief. It includes your contributions, the tax relief added and anything your employer pays in to your pension plan.

For most individuals, the standard Annual Allowance is £60,000, although the amount of personal contributions eligible for tax relief is generally limited to 100% of relevant UK earnings. Higher earners may be subject to a reduced, or tapered, Annual Allowance.

The taper may apply where threshold income exceeds £200,000 and adjusted income exceeds £260,000. In these circumstances, the Annual Allowance is reduced by £1 for every £2 of adjusted income above £260,000, subject to a minimum Annual Allowance of £10,000.

Keeping threshold income at £200,000 or below removes the taper entirely, however large the employer contribution.

The carry forward tax trap

If you didn’t use your full allowance for pension contributions, you fall into the trap of losing it. Fortunately, you can carry unused allowance for three tax years and use it later, provided you held a pension in each of those years.

It works on a rolling basis, oldest year first. Reach a fourth year and the oldest allowance expires.

Planning your contributions and making full use of carry forward could mean cutting your tax burden.

The Child Benefit trap

Child Benefit is not means-tested when paid. However, where the higher earner in a household has adjusted net income of more than £60,000, the High-Income Child Benefit Charge may apply, resulting in some or all of the benefit being repaid through the tax system. The charge increases gradually and can result in the full amount being repaid where adjusted net income reaches £80,000.

The charge is based on the adjusted net income of the higher earner rather than the couple’s combined income.

For example, if both parents have adjusted net income of £60,000, no charge arises. However, if one parent has adjusted net income of £80,000, the full amount of the Child Benefit received may be repayable.

Where appropriate, pension contributions and Gift Aid donations can reduce adjusted net income and may therefore reduce or remove the High-Income Child Benefit Charge.

The inheritance tax trap

Inheritance tax – IHT – is charged at 40% on what your estate is worth above the allowances. The main allowance, the nil rate band, has been £325,000 since 2009, with up to £175,000 more where a home passes to children or grandchildren. Neither has increased, while house prices and portfolios have, pushing many more people into the IHT trap.

From April 2027, unused pension funds will be included as part of your estate for inheritance tax.

Proper succession planning is becoming more vital than ever.

Getting out of the tax traps

With appropriate planning, it may be possible to mitigate the effect of these tax traps. Professional advice can help individuals understand the options available and determine what is suitable for their circumstances.

At Continuum we can look at your tax affairs, and find ways to help keep you, and more of your money, safe from the taxman.

Call us today for a free initial consultation.

Income Tax rates and Personal Allowances : Current rates and allowances – GOV.UK

PTM057100 – Annual allowance: tapered annual allowance – HMRC internal manual – GOV.UK

This article is intended for general guidance only and is based on the opinion of Continuum it does not constitute financial advice. Individual circumstances vary, and you should consider seeking advice from a regulated financial adviser before making any financial decisions.

A pension is a long-term investment; the fund value can go down as well as up and this can impact the level of pension benefits available. Pension Income could also be affected by interest rates at the time benefits are taken. Pension savings are at risk of being eroded by inflation.

Tax treatment is subject to individual circumstances, tax legislation and regulation, which are subject to change in the future.

The Financial Conduct Authority does not regulate taxation and trust advice.