To fully understand your Personal Allowance, it’s imperative that you know the income tax rates for earnings if you live in England, Wales, or Northern Ireland.
When your income exceeds £100,000, it’s important to understand your level of income tax. There are some traps that you can fall into, which means that you can effectively be taxed at a rate of 60%. Let us explore further your tax-free Personal Allowance and how you can make the most of your pension, to avoid this type of tax trap and reduce your tax bill.
Income tax rates explained
The income tax for the tax year is based on two main factors:
- The amount of income above your Personal Allowance
- The amount of income falling within each tax band
The tax rate then falls into four bands, which are as follows:
- Personal Allowance: Taxable income up to £12,570 at a tax rate of 0%
- Basic Rate: Taxable income between £12,571 to £50,270 at a tax rate of 20%
- Higher Rate: Taxable income between £50,271 to £150,000 at a tax rate of 40%
- Additional Rate: Taxable income over £150,000 at a tax rate of 45%
For those living in Scotland, the income tax rates have an additional three bands:
- Personal Allowance: Taxable income up to £12,570 at a tax rate of 0%
- Starter Rate: Taxable income between £12,571 to £14,667 at a tax rate of 19%
- Basic Rate: Taxable income between £14,668 to £25,296 at a tax rate of 20%
- Intermediate Rate: Taxable income between £25,296 to £43,662 at tax rate of 21%
- Higher Rate: Taxable income between £43,663 to £150,000 at a tax rate of 41%
- Top Rate: Taxable income over £150,000 at a tax rate of 46%
You can also use an online income tax calculator as an effective tool to work out how much you will pay, taking into account pension contributions and where you live in the UK.
Personal Allowance explained
The Personal Allowance is the amount of income you can earn before you pay tax, and applies to most people in the UK. For the tax year 2021/2022, this equates to £12,570 as standard – an increase from £12,500 in previous tax years.
This becomes smaller as you earn over £100,000, as your Personal Allowance goes down by £1 for every £2 of your adjusted net income earned above this amount. This means your allowance is zero if your income is £125,140 or above.
Your Personal Allowance works intrinsically with the amount of income tax you pay, and this is where the tax trap can catch you out.
For example, if you have an income of £100,000, every £1,000 above this is taxed at 40% for income tax (as explained above). Based on the ‘£1 for every £2’ calculation, you then lose £500 from your tax-free personal allowance, meaning £500 more of your income will also be taxed at 40%, costing you a further £200.
As a result, you have lost a total of £600 for every £1,000 above the £100,000 threshold thanks to a combination of income tax and a reduced Personal Allowance. Accountants know this as the 60% tax trap and can have a detrimental effect on your wealth.
Contribute to Your Pension
If you contribute to your pension, not only can you reduce your income back to £100,000 (taxed at 40%), you can also regain the full tax-free Personal Allowance. Plus, you’ll also be able to claim tax relief.
Therefore, with some intuitive financial planning or with the help of financial planning services, you can overcome the tax trap by simply using your pension.
Disclaimer: Information is correct to the best of our understanding as of the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.
