Tax Traps and Tax Efficiency

This wiki page outlines methods you might use to reduce your tax liability on your income as well as some of your responsibilities, including whether you need to submit a self assessment to HMRC.

Figures are correct for the 2023-2024 tax year.

What is a ‘tax trap’?

There are some levels of earnings where disproportionately high amounts of tax are paid due to the removal of allowances. The two most common ones are:

  1. The progressive removal of child benefit on earnings between £50,000 and £60,000.
  2. The progressive removal of the personal allowance on earnings between £100,000 and £125,140. Parents also lose access to Tax Free Childcare and some free childcare hours.

Income inside these bands is therefore taxed at a very high marginal rate.

Note – These figures only refer to income tax, and do not include National Insurance contributions. See our Income Tax – The Basics primer for more info on tax.

What is ‘Adjusted Net Income’?

Your “Adjusted Net Income” is your total taxable income from all sources (e.g. salary, bonus, any interest and dividends earned outside of ISAs, any other sources of income such as rental income) minus any pension contributions, Gift Aid payments, and any other allowable reliefs.

Note: If your pension is paid via salary sacrifice, make sure you do not deduct it from your income twice!

Even if non-employment income is under your respective allowance and not taxed directly, it still forms part of your ‘adjusted net income’.

HMRC use your adjusted net income to determine whether you need to pay the High Income Child Benefit charge or whether your Personal Allowance is reduced. So if you can reduce your adjusted net income enough, you can escape these traps.

Note that it is still your income before tax – not your ‘net income’ after income tax and National Insurance!

Using your pension to reduce your adjusted net income

If you’ve followed the flowchart and have money set aside for an emergency fund and for any short term goals, you’re in a great position to benefit from the tax savings of putting money away in a pension.

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

You have an annual allowance for pension contributions, and any contribution within this allowance attracts tax relief at your marginal tax rate (see Income Tax – The Basics for more on this). This allowance applies to both your own and your employer’s contributions.

Your pension allowance is the lower of £60,000 or your annual income (unless you earn over £260,000, in which case your allowance is tapered down).

You can also potentially ‘carry forward’ unused annual allowances from the last three tax years for use in the current tax year.

Is a pension the right choice?

You may be wondering if it is the right decision to increase pension contributions if you weren’t otherwise planning to. We would generally suggest that people work out their long-term goals first, and decide how much to save for them as a result. However, in the situations below, the tax cost of the trap is so high that it makes pension contributions even more valuable than usual. With that said, please ensure you have enough in ‘spare’ funds before making any decisions – you should still be at the “long-term goals” section of the flowchart before considering this route.

Tax relief in the examples – relief at source vs salary sacrifice/net pay

Although the way to achieve the full higher-rate tax relief is quite different in the examples below, the overall effect for the tax traps is the same, although salary sacrifice tends to be preferable as you will save National Insurance on the amount, and you don’t need to reclaim the higher-rate tax relief manually.

See our Pensions page for further reading, specifically the section How do I claim higher rate tax relief?

Tax Trap 1: Removal of Child Benefit at £50,000 earnings

Effective income tax rate on earnings between £50,000 and £60,000 for somebody earning £63,160:

  • With one child: 60%.
  • With two children: 73%
  • With three children: 86%

Parents of children under 20 are usually eligible for child benefit. This benefit is progressively withdrawn for parents earning over £50,000 via the High Income Child Benefit Charge.

For every £100 earned over £50,000, you must repay 1% of the Child Benefit. This results in 100% of the Child Benefit needing to be repaid once you reach an income of £60,000. You can calculate how much you will need to pay here using the governments calculator: https://www.gov.uk/child-benefit-tax-calculator

The High Income Child Benefit charge is based on individual income. Two parents earning £49,000 each can access the full child benefit entitlement but if one parent earns £60,000 and the other earns £0 they are not entitled to any of it.

Example: £50k tax trap + Salary Sacrifice pension

You earn £63,160 and have children. Your employer operates a salary sacrifice pension scheme. The 5% “employee” contribution required for automatic enrolment is sacrificed, bringing your post-sacrifice gross income to £60,000.

In order to retain child benefit, you salary sacrifice £10,000 of your salary to bring your income to £50,000, which means no High Income Child Benefit Charge is due.

Example: £50k tax trap + Relief at Source pension

You earn £63,160 and have children. Your employer operates an automatic enrolment pension scheme, and after your 5% ‘standard’ pension contributions your income is almost exactly £60,000. (Note pension schemes can vary – yours may not be the same!).

In order to retain child benefit, you make a gross contribution of £10,000 to bring your income to £50,000. To get £10,000 into a Self Invested Pension Plan (SIPP), you will need to make a contribution of £8,000. The SIPP provider will automatically reclaim £2,000 (20% tax relief) from HMRC.

As a 40% taxpayer, you will also be entitled to a further 20% tax relief on contributions made within the 40% tax band. You can claim this by contacting HMRC or completing your self-assessment, and any overpaid income tax (but not National Insurance) will be refunded to you.

In this example, assuming the usual higher rate tax threshold of £50,270, all but £270 of your contribution falls in the higher rate tax band. You would receive further tax relief of £1,946. so your SIPP contributions have effectively cost you £6,054 from your take-home pay (i.e. the £8,000 pension contribution from you minus the £1,946 tax refund).

Your adjusted net income income would be £50,000, meaning you would be eligible for child benefit in full.

Tax Trap 2: Removal of Personal Allowance at £100,000 earnings

Effective income tax rate for earnings between £100,000 and £125,140: 61.25%

For every £2 you earn above £100,000, £1 of your personal allowance is removed. The current personal allowance is £12,570 which means that the personall allowance is fully lost at £125,140 of annual earnings.

At earnings of £100,000 access to Tax-Free Childcare is also removed, and some free childcare hours, so it can mean a disproportionately high tax burden for parents at this income threshold, where they may actually end up pay more than £1 tax per pound earnt.

Example: £100k tax trap + Salary Sacrifice pension

You earn £125,140 this year. You sacrifice £25,140 of your salary via a salary sacrifice arrangement and your employer contributes £25,140 to your pension in exchange for your sacrificed salary.

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.

Had you not made this change the £25,140 gross pay would only have provided £10,056 of after-tax income, due to the removal of the personal allowance. Instead, the full £25,140 is contributed to your pension.

Example: £100k tax trap + Relief at Source pension

You earn £131,730 this year. Your employer operates an automatic enrolment pension scheme, and after your ‘standard’ 5% pension contributions your income is almost exactly £125,140. (Note pension schemes can vary – yours may not be the same!).

The £25,140 of earnings above £100,000 result in effective after-tax income of £10,056.

In order to retain your full personal allowance, you make a gross contribution of £25,140 to bring your income to £100,000. To get £25,140 into a Self Invested Pension Plan (SIPP), you will need to make a contribution of £20,112. The SIPP provider will automatically reclaim £5,028 (20% tax relief) from HMRC. You could also make an additional contribution to your workplace pension with the same effect.

As a 40% taxpayer, you will also be entitled to a further 20% tax relief on contributions made within the 40% tax band. You can claim this by contacting HMRC or completing your self-assessment, and any overpaid income tax (but not National Insurance) will be refunded to you. This would be a further £5,028.

As a result, your adjusted net income would be below £100,000, you would regain your personal allowance, paying 40% less tax on another £12,570 of your earnings – a further tax saving of £5,028.

So, in summary:

  • You receive £10,056 net income for your £125,140 gross (60% effective tax)
  • you contribute £20,112 from your own resources to a SIPP or your workplace pension, which is topped up to £25,140 by the provider.
  • you receive additional £10,056 tax relief from HMRC.
  • This means the £25,140 contribution has “cost” £10,056 from your take home pay.

Tax Trap 3: Tapered annual allowance over £200,000 earnings

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 in a tax-efficient way. This applies if both of the following are true:

  1. Your threshold income is over £200,000.
  2. Your adjusted income is over £260,000.

Similar to the gradual loss of personal allowance, for every £2 of adjusted income over £260,000, your pension annual allowance is reduced by £1 down to a minimum of £10,000 at £360,000 adjusted income.

Note: “adjusted income” is not the same as “adjusted net income” which we refer to above.

In this scenario you will pay tax both on entry and exit from the pension so it is highly tax inefficient and you may therefore be better off using other methods of saving.

There is guidance provided by HMRC here, and further information on MoneyHelper. We won’t provide examples here due to the complexities involved – if you are affected you should consider seeking financial advice or speaking to a tax accountant.

Other ways to reduce your adjusted net income

Using your pension is the main method, but there are others available. Salary sacrifice for various perks is becoming more common, but beware that these may attract tax known as “Benefit in Kind” (BiK).

The best known scheme is Cycle to Work, which does not attract BiK, and neither does purchasing of additional holiday days. But other schemes such as car leasing do attract this tax and therefore you should not assume that your adjusted net income will reduce by the full amount you are salary sacrificing.

Cycle to Work scheme (No BiK charge)

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 National Insurance contributions paid.

Owning and using a bike has a great many benefits, but it is additional expenditure and so this should only be used if you can afford the additional cost and actually intend to use the bike. You do not need to prove that you use the bike for commuting, you only need to intend to at the point of joining the scheme.

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.

The £1,200 voucher results in a reduction of £435 in your take home pay, so you have essentially gained £765 in value.

Buying additional holiday days (No BiK Charge)

Many large employers offer the option buy additional holiday days. These are effectively a sacrifice of salary in exchange for working less hours, and so do not attract a Benefit in Kind charge.

Salary sacrifice car leasing (BiK Charge)

A growing number of employers offer salary sacrifice schemes for leasing new cars. Because buying or leasing a brand new car is a luxury purchasing decision, it probably shouldn’t be entered into just to reduce your net adjusted income, but if you would be buying or leasing a new car anyway, it might be worth considering.

The tax effect of these schemes is complicated. The lease attracts a benefit in kind tax based on the list price of the car, with the percentage figure dependant on the emissions rating of the car. As a general rule, ultra-low-emission EVs tend to be the more tax-efficient options. The scheme operator should explain the specifics to you. General information can be found at the RAC website.

Donating to charity / Gift Aid

Donating to a charity can reduce your income tax in a similar way to pension contributions.

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.

Gift Aid 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 a relief for the 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

Payroll giving is another way of reducing income tax liability. It involves electing to donate to charities from your gross salary, removing the need to reclaim Gift Aid.

Because it is an election and not a salary sacrifice, you do not receive NI relief on the contribution, but do receive income tax relief.

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 and you would have lost some of your personal allowance, so in effect, the donation only cost you £2,000 of what would have been your net pay and your full personal allowance is restored.

Tax advantaged investment schemes

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

Although both schemes provide tax relief, they do not reduce your adjusted net income, and so don’t remove you from the tax traps in the way the other options do – they just ‘refund’ some of the additional tax paid via their own reliefs.

Enterprise Investment Scheme / Seed Enterprise Investment SCheme

SEIS and EIS are two similar schemes offering income tax relief (50% for SEIS, 30% for EIS), and no capital gains tax in the 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 total loss is significant.

Venture Capital Trusts

VCTs are a specialist product that offers tax relief to investors who lock their money away for at least 5 years.

They offer 30% income tax relief, as well as tax-free dividends, and CGT holdover on reinvestment.

They are invested in groups of small unlisted companies and are considered a very high-risk investment with a significant risk of capital loss. You can read more about them here.

Do I need to complete a Self Assessment?

If you enter either of these tax traps you may be required to complete a Self Assessment Tax Return to ensure you are taxed appropriately.

HMRC have a guidance page on who should fill in a tax return, with one of the triggers being “earnings over £100,000” (changing to £150,000 in 2024/2025 tax year), although accountants and tax experts argue that there is no requirement in law to do so unless HMRC specifically request it.

If HMRC issues you with a notice to file, you must submit a tax return. Even if you think you will not owe any additional tax, failure to do so will result in penalties, such as a late submission and interest charge.

You can request that the notice is withdrawn if your affairs are simple – and can be dealt with via PAYE. The notice must be withdrawn before the submission deadline to avoid penalties.

Furthermore, if you have not received a notice to file but you knowingly owe tax then you must notify HMRC (although not necessarily via tax return – you can contact them directly if the tax owed is straightforward). This applies to your earnings from other income or gains. This includes but is not limited to income such as:

This is not an exhaustive list and if you have any other income which is taxable HMRC must be informed. You can use the gov.uk website as a guide to finding out if you might need to submit a tax return. If you are unsure seek professional tax advice.

Should I claim child benefit if I have to pay it back?

If you earn between £50,099 and £60,000 and are unable to reduce your income any further using tax efficient means then you are still better off claiming child benefit even if you have to pay some or most of it back at the end of the year. You could always set the money aside in a high interest account until you need to pay it back, allowing you to keep any interest earned.

If your income is above £60,000 even once you factor in all salary sacrifice/pension contributions and reliefs and you are not in a position to lower it further you should still register for child benefit and opt not to take the money.

This is because parents registered for child benefit of children under 12 receive Class 3 National Insurance credits, which can make up any qualifying years for state pension that are not earned via employment (e.g. if one parent stays at home to care for the child or works too few hours to pay sufficient Class 1 or 2 contributions to make the year a qualifying year).

Registering also means your child will be automatically issued a National Insurance number 3 months before they turn 16. Additionally, if your circumstances change and you become eligible to keep some or all of the money you can receive this faster if you have already registered.