The 80% Tax Trap (Taking the 60% Tax Trap One Step Further)

You may have heard people state than an individual’s earnings over £100,000 can be impacted by a 60% tax trap. This means that by exceeding £100,000 in earnings, an effective 60% tax trap begins as your personal allowance is lost by £1 for every £2 over this amount, alongside being subject to 40% higher rate income tax.

However, it can be even worse than this and I recently came across this scenario at one of my client meetings. Please note that names and information have been changed, but I wanted to illustrate how a potential 80% tax trap can occur with the below case study, and how we overcame this problem for our clients.

Case Study

Sebastien is 40, married to Alexa and they have two children. Thomas and Amelia are aged 5 and 7 and attend various forms of registered childcare and holiday clubs that cost around £30,000 annually.

Sebastien works full time and earns £120,000 and Alexa is a doctor on reduced hours earning £80,000. After income tax and National Insurance deductions are made, Sebastien and Alexa take home a net joint income of £133,122 (£76,161 and £56,961). Their outgoings are around £10,000 per month, which includes mortgages, living, childcare costs and holidays. Sebastien and Alexa keep cash savings of around £60,000, covering six months of expenditure need for rainy days.

They would desperately like to know what help is available to them as they do not qualify for any free hours of childcare, working tax credits, and did not apply for childcare vouchers before this option was removed. Unfortunately, as Sebastien’s adjusted net income is above £100,000 a year, both him and Alexa also do not qualify for any Tax-Free Childcare (Tax-Free Childcare provides each parent with up to £10,000 each in every tax year (including £2,000 tax relief by saving £8,000 each annually into a Tax Free Childcare account to be used on registered childcare. This is an additional 20% tax relief for each parent if they qualify)).

After discussing their situation, we established that with a few small sacrifices to living costs, they could afford to save around £16,000 annually, so £1,333.33 on a monthly basis.

We therefore discussed using these annual savings to make a personal pension contribution of £20,000 gross for Sebastien. This would amend his adjusted income to below £100,000 and would initially cost him £16,000 to make a gross £20,000 pension contribution.

By doing this, Sebastien achieved an effective 80% tax relief overall between him and Alexa by:

• Regaining his personal allowance and avoiding the 60% tax trap, where income on the first £12,570 is subject to 0% income tax.

• Achieving an overall 40% income tax relief on the pension contribution (20% tax relief at source and 20% income tax relief via his tax return).

• Ensuring that both him and his wife can qualify to use the Tax Free Childcare accounts, as Sebastien’s adjusted net income was reduced to below £100,000, both achieving a 20% tax relief on the maximum £10,000 savings amount to be used on qualifying childcare, i.e. £4,000 tax relief (2 x £2,000 Tax Free Childcare accounts tax relief).

• Added £20,000 to his pension pot for his future retirement.

This financial planning for Sebastien and Alexa effectively achieved 80% tax relief and is one of many examples where financial planning can maximise the tax efficiency over your working life and beyond. Full consideration should always be given to your individual situation alongside your overall objectives.

I appreciate this is niche, but it goes to show how planning can give you a boost in returns (a tax alpha!)