Over the course of the festive season we’ll be bringing you an advent calendar’s worth of tax and financial tips. Some of them might even be a little Christmassy! Ever fancied becoming an alchemist? On day 9 of advent we tell you how you can when…
Earning over £100,000
Once you start to earn over £100,000 the government begins to claw back your tax free personal allowance. You give back £1 of personal allowance for every £2 you earn above £100,000. In both the 2019/20 and 2020/21 tax years, your personal allowance is therefore completely lost once your earnings reach £125,000.
So if you earn £100,000 and you expect income to rise to £110,000, how much of that £10,000 rise hits your back pocket? The answer is much lower than you think: just £3,800.
A way of mitigating this 62% tax rate is to make an £8,000 pension contribution (or charitable donation). This has the effect of reducing your income back below £100,000 and restores your full personal allowance.
Why is this better I hear you ask? After all, you’ve gone from receiving £3,800 of net income to having to pay out £8,000.
Let’s analyse the effect of the pension contribution: you’ll save £2,000 of tax by retaining your full personal allowance plus you’ll get a £2,000 tax refund due to higher rate tax relief. So the cost of the contribution is ultimately £4,000 – not £8,000.
Now here’s the kicker: following your pension contribution, the government contributes a further £2,000 so you will have £10,000 sitting in your pension pot. OK you can’t access that £10,000 (plus growth) until you retire but, in effect, tax alchemy has allowed you to turn £3,800 of lumpen lead into five gold rings worth £10,000.
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