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

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

However, my income puts me in a position where my personal allowance is waived, effectively paying 60 percent tax on that pay rise.

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

So far this hasn’t really affected me much as my employer manages our pension scheme through salary sacrifices and I pay 5 per cent of my salary which reduces my income by £5,250.

However, now I find myself losing the lion’s share of my raise. I’ve been told that if I pay additional retirement contributions for a self-invested personal pension, it will lower my taxable income and may restore my personal deduction.

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

Tanya Jefferies, from This is Money, replies: Many more people will be pushed into higher tax brackets as their pay rises in the coming years, and will likely consider putting extra into their retirements to lower their wages and thus their tax burden.

The most recent projections from the Office for Budget Responsibility, released with the March budget, showed there would be 2.1 million new higher-rate taxpayers between 2021/22 and 2027/28 – a 47 percent increase from 4 .6 million to 6.7 million.

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

There is a summary of the effects of new fiscal ‘cliffs’ here, and Simon Lambert, editor of This is Money, calls on the chancellor to resolve them here.

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

In the current tax year, which ends next Wednesday, April 5, you won’t be able to take advantage of this for long.

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

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

As you have established, this is most beneficial to those with incomes of just over £100,000 when they lose their personal allowance.

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

Although income that falls in the higher rate bracket is taxed at 40 percent, the phasing out of the personal allowance means that part of your income can effectively be taxed at no less than 60 percent.

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

So to understand your position after your new pay rise, your new salary of £110,000, which works out to £104,750 after your 5 per cent pay cut, effectively means that you would now pay £1,900 in 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 a further £950. As a result, earning £5,000 would increase your taxable income by £4,750 (after your existing pension contributions), which would cost you £3,325 in tax, equating to an effective tax rate of 60 per cent.

One way to reduce the so-called “60 percent tax trap” is to save for any kind of retirement.

If you paid a gross pension contribution of £5,000, your adjusted net income would fall below £100,000, restoring your personal allowance and giving you a 60 per cent tax credit on your pension contribution.

Of course, these figures are based on the total annual income. If you get a pay rise halfway through a tax year, the difference isn’t that big.

A pay rise of £5,000 per annum in September would mean that your annual income had increased by £2,500 in the tax year. So you may only have to contribute around that amount.

To make a difference in this tax year you should make a contribution before April 5 to reduce your income before the end of the tax year and if you have the means to make a retirement contribution it would be well worth it must be to do this.

We’ve seen a lot of pension policy changes recently and there’s now a cap of £60,000 annual pension payment, but you’d be well below that, with the salary sacrifice of £5,250 and the Sipp contribution of £2,500.

I’m also unsure of the value of your total retirement savings, but there is now no current lifetime limit on the amount you can invest in a retirement.

Retirements are complicated as your situation emerges and understanding the tax situation and its impact on your overall finances can be mind boggling, which is where getting smart advice can help.

In general, an advisor will take a thorough look at your financial situation and your income and determine which pension contributions are appropriate for your individual situation.

They can also help you choose the right pension fund for your needs, advise you on other tax-advantaged forms of investing and keep you informed of any changes in pension rules.