Thoughts To Help You Plan Around UK Income Tax & Benefit Thresholds
You go to work, earn your salary and pay taxes. Great, but have you ever sat down and reflected on how to optimise your pay by planning around income tax and benefit thresholds?
The UK may not be perfect and is far from the romanticised social welfare society seemingly exemplified by Scandinavian countries, however the UK does try. So I’m hoping you read this and feel good, knowing that your income tax helps to pay for the country’s defence services, it’s health, social services, transport systems and a host of other things which make the UK a great place to live. If only taxes could also be used to sort out the weather……..
In addition to the standard 20%, 40% and 45% tax rates and the hidden marginal tax rate of 60% (more on this later), there are also benefit thresholds in areas such as child benefit, free child care, parental contribution to university fees and pension allowance. I think the Tax Man is trying to tell us something, with the way income tax thresholds are set and the benefits you loose or gain along the way. Some of these tax rates and thresholds don’t seem logical to me, but there’s no point trying to fight the Tax Man (other than by public campaigns and/or by voting in a government that shares your views). Rather, it seems we are better off paying the taxes due, understanding the rules and trying to plan around them in a way that suits our lifestyle.
I’ll start by summarising the income tax rates and bands and some important benefit thresholds, and then provide some thoughts on how to utilise this information to plan around your lifestyle.
The UK Income Tax Rates And Bands
This information is widely publicised, but just to recap: the income tax we pay each tax year is dependent on how much of our income is above the personal allowance and how much of our income falls within each tax band. A tax year runs from 6th April one year to 5th April the following year and your income for tax purposes is the sum of all your earnings in that tax year. (nb - some people ‘forget’ to include their side hustle income, which could land them in hot water if caught).
Based on the 6th April 2021 to 5th April 2022, tax year
There’s no tax to pay on the first £12,570 (Personal Allowance)
You pay 20% tax between £12,571 and £50,270 (Basic Rate)
You pay 40% tax between £50,271 and £150,000 (Higher Rate)
You pay 60% tax between £100,000 and £125,000 (Hidden Marginal Rate)
You pay 45% tax on income over £150,000 (Additional Rate)
Rather than having loads of text to explain how your net income is worked out based on these tax rates and bands, It’s easier to use an online income tax calculator and play around with different assumed salaries. Have a look at the one by money saving expert here
We’ll need this link for some of the exercises later so please keep the page open in your browser
You’ll note that I’ve included a hidden marginal rate of 60% tax in RED above, which you won’t find on the UK government website. Now you might be thinking .. I don’t give two hoots about the [lucky/hardworking/insert your own word] so and so who earns between £100k and £125k a year. So I’ve provided the explanation in a box below, which means you can conveniently skip the section if it doesn’t apply to you.
You Pay 60% Tax on Salaries Between £100k and £125k
Recall that you don’t pay any tax on the personal allowance: i.e. the first £12,570 (in the 2021/22 tax year). Well, everything changes once you start earning over £100k. The rules state that the personal allowance reduces by £1 for every £2 you earn over £100k. This has the net effect of pushing more of your income into the 40% tax bracket. This is best explained with a worked example.
Say you earn £110,00 per annum
It means you earn £10,000 over £100,000
So your personal allowance is reduced by £10,000/2 = £5,000
Meaning your tax free personal allowance is now £12,570 - £5,000 = £7,570
From the £110k, (£7,570 is taxed at 0%), (£37,700 is taxed at 20%) and (64,730 is taxed at 40%)
You will note that in addition to paying 40% tax on the £10,000 over £100,000 you are also paying 40% on £5,000, which you would have otherwise not paid as it would have been tax free.
40% of £10,000 = £4k and 40% of £5,000 = £2k
So you’ve paid £6k tax on the extra £10,000 you earned = 60%… OUCH
There are loads of means tested benefits available including Universal Credit, Housing Benefit , Income Support, Council Tax Support and Child Benefit. It is not my intention to go through the UK benefits system as that’s a lot of ground to cover. Rather, I’ll pick out a few benefits that most working adults will likely consider at some point. Having said that, if you are struggling on a low income, I’d suggest trying out the entitledto free benefit calculator Specifically, if your COMBINED (i.e you alone if a single parent or you and your partner if not a single parent) family income is less than about £40,000 you may qualify for universal credit.
This is a benefit of £21.15 a week (£1,100 a year) for the 1st child and £14 a week (£728 a year) for other children. You can claim for each child until they are 16 years old or until 20 years old if they stay in approved full-time education such as A-Levels. You can’t retain this benefit if either you or your partner earn over £60,000. If either you or your partner earn over £50,000 you’d need to pay back 1% of the child benefit for every £100 of your income over £50,000. You may have spotted a quirk of this benefit threshold: a family with one person earning £80k and the other earning £20k, working part time won’t get this benefit, whereas a couple with both earning £50k will get this benefit.
Note that it is worth claiming Child Benefit as soon as the child is born as your payments can only be backdated three months from the date your application is received.
30 hours Free Child Care
This summary is based on England only, but Scotland, Wales and Northern Ireland also have similar schemes. You get 15 hours free child care per WEEK if your child is between 3 and 4 years old. This is doubled to 30 hours free per WEEK if you and your partner each earn less than £100,000 per year. You can apply for it here https://www.gov.uk/apply-30-hours-free-childcare Again, you’ll note that a family with one person earning £110k will not get this benefit, while a family with two people each earning £90k will get this benefit.
Pension Annual Allowance
This isn’t a benefit in the conventional sense, but I’m including a short description here as I’ll be touching on it later on. The annual allowance is the most you can save in your pension pot in a tax year, without incurring tax. The annual allowance is £40k for the 2021/22 tax year. This means, that theoretically you could put £40k in your pension every year and watch it grow with the stock market so that you have a £1million pension pot by the time you retire. Although, you don’t really want it to grow past £1,073, 100 (the lifetime allowance) as you may end up paying more tax otherwise.
Unfortunately things are not straightforward with pensions and you’ll need to either seek the advice of an expert or google and read widely. For starters, most employees get both employer and employee pension contributions and some people are in defined contribution pension schemes. This makes it a bit challenging to work out precisely how much of the annual £40k allowance has been used up. Nevertheless, this summary will hopefully make you curious to learn more.
For the super, super high earners, it’s also worth mentioning the Tapered Annual Allowance (TAA). A bit of a complicated mess to explain, but the key message is that you should seek advice the moment you start earning over £200k a year (lucky you). For every £2 of income above £240k, you lose £1 of annual allowance and by the time you start earning £312k a year or more, your allowance is reduced to £4k….. don’t expect any sympathy from anyone though.
Finally, I want to mention Pension Carry Forward, which allows you to use your unused pension allowance from the previous 3 tax-years in the current tax year. For example, say your ‘Man Not Cold’ song from a tik-tok comedy sketch became an actual commercial hit and you made windfall profits of £300k in one tax year. Say you’d only contributed £5k into your pension each year for the last 3 years. This would mean you have unused allowances of £35k in each of the previous 3 years (£105k in total) plus the £40k for the current year. This means you can contribute £145k into your pension pot and since this is before tax, you will be paying much less tax on the £300k than you would have, had you decided not to trigger pension carry forward. Of course the downside is not being able to access the pension money till you are 55 years old (nb – based on current 2021-22 rules).
University Maintenance Loans
Pretty much all first-time UK undergraduates can have their tuition fees paid by the Student Loans Company and it only needs to be repaid once students earn over a certain amount after they leave. The loans for tuition fees are not means tested, but the maintenance (living) loan is means tested and this is the bit I’m going to focus on.
The living loan is designed to help students with living costs while studying. The size of the living loan (which ranges from a minimum of about £3,500 a year to a maximum of about £12,300 a year) depends on family income and whether a student lives at home or goes away to study. The amount of loan you can get starts to reduce when total family income is about £25k a year, is pretty much halved by the time it reaches £60k a year and disappears altogether by £70k a year. The rules are a little different for Scotland, Wales and Northern Ireland.
Implicit in this arrangement is that parents are expected to foot the bill for the shortfall between the amount of living loan the child qualifies for and the maximum loan of about £12,300 a year. Martin Lewis from money savings expert has done an excellent job in explaining the details and also has a helpful calculator which you can find here
Now that I’ve summarised the UK income tax rates and bands and a few benefit thresholds, I’ll now provide some thoughts on planning around them. My hope is that as you read, you begin to formulate your own thoughts on how you could flex different elements to suit your lifestyle.
Consider keeping your income under £50k a year
Are you crazy Bemi? What have you been smoking? Why would I want to keep my income under £50k a year if I could earn more? Well, I think it’s only right to first mention that £50k a year is a hec of a lot of money for most people, particularly if you live outside London. The median annual earnings for full-time employees in the UK is about £30k. So, it’s a good ‘problem’ to have…..Having said that, let’s have a look at some of the advantages of keeping your income under £50k a year
You get to stay within the basic rate of tax (20%)
As an exercise, I’d like you to use the Income Tax Calculator mentioned earlier to work out the difference in net pay between a salary of £50k a year and a salary of £60K. I’ve provided a screenshot of the results below. You’ll see that the £60k salary allows you to take home £836-£724 = £112 more a week than if you earned £50k a year. This represents a 15% increase in NET pay. However the tax paid increases by £220-£144 = £76 a week. This represents a 53% increase in TAX. I’ll be honest – I wasn’t expecting such a huge disparity between the percentage increase in NET pay vs TAX. Not to mention the accompanying increased responsibilities, which often (but not always) translates to poorer work-life balance.
Quite a few professional and middle management jobs pay between £55k and £65k a year. If you fall into this category, it’s worth taking a closer look at your living expenses and seeing if you can live off £50k a year in order to optimise your income from a tax perspective. Depending on your personal situation and goals, it might make more sense to salary sacrifice the extra amount over £50k into your pension. If considering doing this, don’t forget to factor your bonus if you get one.
Note that the above discussion has focussed on PAYE salaries from an employer. If you are self-employed or own your own business, it’s worth having a discussion with your accountant as the strategies are a little different. Probably an article for another day.
You get to retain child benefit payments
For a family with two children, the total child benefit payment comes to about £1,800 a year. Note that this is a net amount going into your bank account every year for 16 years. Depending on your income tax band, you’d probably need to earn in excess of £2,500 gross income to get to a net income of £1,800 a year. The point is that this is a highly valuable benefit. Does it really make sense to earn £55k a year and loose out on this benefit, when you could salary sacrifice £5k into say a pension and still get the full child benefit?
If you are a high earner and your industry allows it, would it make sense to work say 3 days a week and earn just under £50k a year and then use the rest of the time to build a side business? Note that if the side business is set-up properly, you could pay corporation tax and leave the rest of the profits in the business to be re-invested to grow the business.
Your kids may qualify for higher student maintenance (living) loan payments
Picture a scenario where you’ve been working hard for the last 30 years and perhaps deferred the execution of a number of dreams along the way. Now your kids are much older and are about to head to university. Your earnings in your main job are higher than they’ve ever been, but you’re itching to do something different: like travelling around the world, working for a charity, or starting a fun side business you’ve always dreamt about.
By planning ahead, you might decide to reduce your expenses and perhaps work part-time if your industry allows it. Planing ahead could mean that the kids qualify for a higher amount of living loan payments than they otherwise would get.
TWO salaries in a household might be better than ONE
Let’s go back to the Income Tax Calculator. This time I’d like you to compare the net income from two salaries of £40,000 versus one salary of £80,000. I’ve pasted the results below. Two people earning £40k a year each will take home (£30,864 x2) £61,728 per year combined vs one person earning £80k a year taking home £55,093 a year. That’s a difference of £6,635…… WOAH
Unfortunately, the maths does not work well when kids get thrown in the mix since it might cost upwards of £10k a year to have a child in nursery while both parents work full-time, not to mention x 2 of costs such as transportation costs. Therefore it might be more cost-effective for one parent to stay at home and for the other to earn as much as possible. Nevertheless, it seems to me that once the kids are in primary school, it might make sense to have both parents earning up to £50k rather than one earning more than £50k and the other one not working.
Recall that in addition to being in the higher rate tax band, you start to loose the maximum child benefit, once one parent in the household starts to earn more than £50k. Furthermore, you loose out on the 30 hours per week free childcare benefit for 3-4 year olds (in England), once one parent in the household starts to earn more than £100k. Then there’s the marginal tax rate of 60% between £100k and £125k to think about. The cumulative impact of all these factors is to make it very unattractive to have one parent earning and the other not working.
Having said that, I recognise that there are some major non-monetary benefits of having one parent at home, not least the increased quality of life in some scenarios. At this point, I think I should stop and highlight one IMPORTANT consideration related to CHILD BENEFIT that sometimes gets missed. If you are in a situation where one partner is earning more than £60k a year, it still makes sense for the partner NOT EARNING an income to claim the child benefit and then pay it back at the end of the tax year. Please have a look at the detailed advice from the UK Department for Work and Pensions arm’s length body called the Money Advice Service (soon re-branding to MoneyHelper) The two main reasons for the advice are:
Claiming Child Benefit will help you protect your State Pension, if you’re at home looking after your children and not paying National Insurance, as you’ll get credits towards your State Pension. You need about 35 qualifying years worth of credits to get the full State Pension (nb – there is an option to fill in the Child Benefit claim form and state you don’t want to receive the payments and still qualify for credits towards your State Pension)
You can put your Child Benefit aside in a savings account and earn interest on the money before you have to pay it back at the end of the tax year.
One final point to consider related to the question of two people in a household working rather than one, is the TYPE of work. Theoretically, one person could do the conventional 9-5, while the other strives for a side-hustle type business, but set up in a way so that they can draw income flexibly in a tax efficient manner. In this day and age, it’s easier than ever to start a small business: market stall selling food, property business, consultancy, cake business, hairdresser, wedding planner e.tc
Avoid the £100k tax trap like a plague
Not always, but more often than not and depending on the industry, the effort required to rise to and maintain a low six figure salary role is MASSIVE. Sacrifices often have to be made in work-life balance; less time for anything remotely fun; if co-parenting, usually the other parent has to stay at home; huge pressures all round. When you then add the tax and benefit implications as outlined previously, you might begin to wonder if it’s worth it.
Perhaps it’s worth it if you haven’t bought your home and need to show the highest possible salary to the mortgage lender in order to buy the house of your dreams. Perhaps it feels good to know you’ve made it to the exclusive club of those earning 6 figures. Maybe it’s the status or the sense of achievement. Could it be the power that comes with being a boss that makes it worth it?
My personal view is that the £100k tax trap should be avoided at all costs, unless you think you’ll only remain there for a short time before the skills gained elevate you to income levels (i.e >£200k), that diminish the impact. This is not to say, don’t accept a salary of say £120k but rather I’m saying that if this happens, you should seriously consider heading this off by salary sacrificing into your pension to put you under £100k income. Taking this further, you could plan things such that by the time you hit a salary of say £160k in a particular year, you use Pension Carry Forward to reduce your income to less than £100k.
One additional point for consideration is that if an employer is willing to pay you 6 figures to OWN you in order to serve the business’ interest, what does that say about about what your skills and talents could earn if working for yourself? Could it be worth your while to find out? Not necessarily by quitting in one big bold move, but by reducing your commitment (e.g. by working part-time or taking a less demanding role). I recognise this is not easy. It requires a solid plan and HUMILITY.
Watch out for the TITLES that make you feel good but don’t add much to your life financially
Imagine being at an evening dinner with strangers or even with friends for that matter. What’s one topic that’s most likely to come up at some point? Yes.. exactly.. at some point, people are bound to start discussing what they do for a living. Now imagine people are throwing around titles such as Head of x or Manager of x or Director of x, would you be comfortable saying you are Junior x? How about if you knew for a fact that despite being Junior x, your industry or company pays more than a manager title in another company, would that make you feel a little better? Let’s take this further. What if you were earning significantly more than everyone else as a result of having a side business in addition to your Junior x job title, would that change your feelings? A topic for another day, but this should get us thinking about whether work defines us. Strip away the title and the job and even the money – do you still feel a sense of worth?
Titles are great for signalling the level of responsibility you have. Titles also have monetary value as they are indicative of how much prospective employers need to offer to attract you. However, titles can also be used to make you feel good, without adding that much in PAY or SKILLS. This is the situation to watch out for. In my humble opinion, there’s nothing worse than having a fancy title that’s come with a small salary increase that tips you over an important threshold (e.g. £55k salary, tipping you over £50k threshold for the reasons mentioned previously) and increases your workload, particularly if you’re likely to remain at this level for the next 10 years. Note that it’s a different matter if it’s a conscious decision to learn REAL MARKETABLE SKILLS that can elevate you.
You might be thinking that this is a wacky point to raise, but I’ve observed how people can constrain their thinking to the microcosm of their immediate work environment and begin to covet work titles that make them look good in that microcosm, whereas if they lifted their head up like a meerkat and considered things from an industry wide or societal perspective, there’d be other more strategic career moves they could make.
From an employer’s perspective, this works like magic. Create a ladder and add lots of rungs with very small increases from one rung to the next. Do a good job of branding the rungs so that the job titles are lovely. Then make employees jump through all manner of hoops to get up the rungs of the ladder. It’ll keep them motivated as they can look back every couple of years and say ‘I was there but now I’m here’.
If I have convinced you of nothing else, I hope that at the very least, I’ve convinced you that simply showing up for work and collecting your salary, without thinking about income tax or benefit thresholds is not ideal from an income optimisation perspective, particularly if you have kids. The thoughts expressed in this article are just to get you thinking. They are not meant to be prescriptive and you might very well disagree with a lot of what has been written. I should mention two key points that might limit your flexibility to plan around income tax and benefit thresholds:
Your ability to plan is reduced if saving to buy a home
If saving to buy a home, you’ll need to earn as high a salary as possible: not just to increase the amount of deposit saved but also to have the best chances of getting a suitable mortgage. This is because most mortgage lenders use a salary multiple of 4 to 5 times your salary to work out the maximum they’d be prepared to lend you. So for example, if you earn £50k a year, a mortgage lender might lend you £200k or £250k. This massively reduces you ability to plan around income tax and benefits thresholds as you’re less able to flex.
You need to be living significantly below your means
Imagine Mohammed Ali boxing with heavy weights strapped onto his back. He definitely won’t be floating like a butterfly and stinging like a bee. All those jabs and hooks from his opponents would probably land a lot more often. Similarly, it’s extremely hard to plan around income tax and benefit thresholds if you are not living significantly below your means. How can you make the decision to salary sacrifice into your pension, when you need every last £100 just to get through the month?
That’s it for this post. Thanks for reading and I hope it’s added value.