Tax efficiency for high earners

So you’ve started earning £100k+ and are wondering what to do? Perhaps you’ve heard about the dreaded 60% marginal rate tax trap and want to avoid it?

This wiki page outlines methods to reduce your tax liability on your income. Numbers are correct for the 2022-23 tax year.

Personal allowance

For every £2 you earn above £100,000, you lose £1 of your personal allowance. For the 2022-23 tax year where the personal allowance is £12,570, it effectively means you are paying a marginal rate of 63.25% (income tax + NI + loss of personal allowance) from £100,000 to £125,140.

Note: all income sources are considered e.g. bank interest and dividends, not just your employment income e.g. salary and bonus. Even if non-employment income is under their respective allowance and not taxed directly, they can still increase your gross annual income and reduce your personal allowance!

Pension

You have an annual allowance for pension contributions every tax year, and any contribution within this allowance attracts tax relief at your marginal rate of tax. If your gross annual income (before any personal pension contributions) is under £200,000, then you have the full annual allowance of £40,000. This allowance includes both your own and your employer’s contributions.

If you’ve followed the flowchart, have an emergency fund in place and do not have any other short or medium term financial goals, then putting money away in a pension is probably the most tax efficient way to save for retirement.

Pensions allow you to defer any income tax today (and NI if done via a salary sacrifice) until retirement, when hopefully you will withdraw at a lower marginal rate.

Example 1

You earn £125,000 this year. You sacrifice £25,000 of your salary via a salary sacrifice arrangement and your employer contributes £25,000 to your pension.

Your taxable income in your P60 is £100,000 and you retain the full £12,570 personal allowance and save the NI on the earnings you forewent. This means the contribution attracted effective tax relief of 63.25%.

Example 2

You earn £125,000 this year. You contribute £20,000 to your SIPP which is immediately uplifted 25% by the SIPP provider to £25,000. This is relief for basic rate income tax at 20%.

As a higher rate or additional rate taxpayer, you must claim back further income tax relief by entering your SIPP contributions in your self assessment. This raises your basic rate band from £50,270 to £75,270, and extends the £100,000 threshold at which personal allowance is lost such that it is restored by £1 for every £2 of gross SIPP contributions. In this case, the gross SIPP contribution is £25,000 and the entire personal allowance is restored.

After contacting HMRC or completing your self assessment, any overpaid income tax (but not NI) is refunded to you. In this example you would be due a further £10,000 tax refund.

Carry forward

You can carry forward unused annual allowances from the last three tax years for use in the current tax year, allowing you to contribute more than your annual allowance, if the following are true:

  1. You earn at least the amount you wish to personally contribute.
  2. You have been a registered member of a UK registered pension scheme in each of the tax years you wish to carry forward.

Any used carry over is allocated to the earliest tax year possible.

Example

You earn £150,000 in the 2022-23 tax year. You were self-employed in 2019-20 and did not have any pension schemes in your name. You then started work with an employer who offers a workplace pension scheme in the 2020-21 tax year and made the following total pension contributions:

2020-21£20,000
2021-22£30,000

Your carry over is:

2019-20£N/A
2020-21£20,000
2021-22£10,000

You have no carry over from 2019-20 because you were not a registered member of a UK registered pension scheme in that tax year.

You have an allowance of £70,000 in the current tax year (£40,000 from the current tax year + £20,000 from 2021-22 + £10,000 from 2020-21).

You contribute £50,000 via salary sacrifice and your employer contributes £10,000 separately for a total of £60,000.

Your taxable income in your P60 is £100,000 and you retain the full £12,570 personal allowance.

Your carry over for the 2023-24 tax year is:

2019-20£N/A
2020-21£0
2021-22£10,000

You used £20,000 from your carry over, which is allocated to the earliest tax year (2020-21) first.

Tapered annual allowance

If your gross annual income is over £200,000 you may be affected by the tapered annual allowance (TAA) which reduces the amount you can contribute to your pension. This applies if both of the following are true:

  1. Your threshold income is over £200,000.
  2. Your adjusted income is over £240,000.

To work out your threshold income and adjusted income, see HMRC guidance and this factsheet that contains good worked examples.

Similar to the gradual loss of personal allowance, for every £2 of adjusted income over £240,000, your pension annual allowance is reduced by £1 down to a minimum of £4,000 at £312,000 adjusted income.

Salary sacrifice schemes

Your employer may offer salary sacrifice schemes that allow you to make a purchase using your gross salary similar to pensions, reducing your income tax and NI liabilities.

Cycle to Work

Cycle to Work allows you to purchase a bike and hire it from the scheme provider using a voucher paid from your gross salary under a salary sacrifice arrangement. This voucher is typically repaid over a period of 12 months directly out of your payroll.

This reduces your taxable income and the amount of income tax and NI contributions paid.

There are different scheme providers with varying rules on how to obtain eventual ownership of the bike.

Example

You obtain a £1,200 Cycle to Work voucher, which costs you £100 of your gross salary per month over 12 months.

You earn £125,140 and have no personal allowance. Obtaining this voucher reduces your taxable income by £1,200 to £123,940, saving you income tax and NI on the £1,200 as well as restoring your personal allowance by £600.

In effect the £1,200 voucher only cost you £435 of what would have been your net pay.

Donating to charity

Donating to a charity can reduce your income tax in a similar way to pension contributions. Donations can be made either from your gross salary via a salary sacrifice arrangement (known as Payroll Giving) or from a direct contribution (similar to SIPP contributions using net income).

Gift Aid

When making a donation to a charity, fill in a Gift Aid declaration and the charity can immediately claim a 25% uplift on your donation which is relief for basic rate income tax at 20%.

As a higher or additional rate taxpayer, you can claim back additional income tax relief by entering your Gift Aid donations in your self assessment.

Example

You earn £105,000 this year. You donate £4,000 to a charity and fill in a Gift Aid declaration. The charity claims an additional 25% (£1,000) on top of your donation, totalling a gross donation of £5,000. This is relief for basic rate income tax at 20% and is given to the charity.

As a higher rate or additional rate taxpayer, enter your gross Gift Aid donations in your self assessment. This raises your basic rate band from £50,270 to £55,270, resulting in £5,000 that would otherwise have been taxed at 40% or 45% to be now taxed at 20% which is a relief of 20% or 25% respectively. In addition, this extends the £100,000 threshold at which personal allowance is lost such that it is restored by £1 for every £2 of gross Gift Aid donations. In this case, the entire personal allowance is restored.

After completing your self assessment, any overpaid income tax (but not NI) is refunded to you.

Carrying Gift Aid into a previous tax year

It is possible to carry the gift aid from a charity donation into the previous tax year. This can be a useful “emergency option” because of this unique feature (assuming you were planning to give to charity anyway).

There are more details available at gov.uk https://www.gov.uk/donating-to-charity/gift-aid 

Payroll Giving

Example

You earn £105,000 this year. You sacrifice £5,000 of your salary to donate to a charity via Payroll Giving with your employer. That £5,000 donation would have been taxed at 40% otherwise, so in effect the donation only cost you £3,000 of what would have been your net pay.

In addition, this reduces your taxable income in your P60 to £100,000, restoring your personal allowance to the full £12,570.

Tax advantaged investment schemes

There are a handful of tax advantaged schemes for investing into eligible small UK companies. These come with a significant risk of capital loss so the government offers advantageous tax conditions to incentivise investors.

SEIS/EIS

SEIS and EIS are two similar schemes that offer income tax relief (50% for SEIS, 30% for EIS), and no capital gains tax in the (unlikely) event of an exit after 3 years. In the likely event that loss occurs, they also offer loss relief. This scheme involves direct investments in unlisted companies and the risk of failure is significant.

Two popular platforms for finding eligible companies are CrowdCube and Seedrs.

VCT

VCTs are a very specialist product that offer tax relief to investors who lock their money away for at least 5 years. They are invested in groups of small unlisted companies, and are considered a very high risk investment. You can read more about them here. They offer 30% income tax relief, as well as tax-free dividends, and CGT holdover on reinvestment.