I'm paying 60% tax on a £5,000 pay rise: Will topping up my pension help?

I got a £5,000 pay rise last summer which took my salary from £105,000 to £110,000 a year.

However, my income puts me in a position where my personal allowance is removed, meaning I’m effectively paying 60% tax on that raise.

This seems extremely unfair considering that the highest tax rate for those earning significantly more than me is 45%.

I pay 60% tax on a £5,000 pay rise: Will topping up my pension help me?

So far it hasn’t really affected me as my employer runs our pension scheme by sacrificing salary and I pay 5% of my salary which reduces my income by £5,250.

Now I find myself losing the lion’s share of my raise. I was told that if I made additional pension contributions to a self-invested personal pension, it would reduce my taxable income and may restore my personal allowance.

I have savings that I could use to put £5,250 into a pension. Would this reduce my income to £100,000 and get me out of this tax trap. Do I have to do it before the end of the tax year?

Tanya Jefferies of This is Money responds: Many more people are going to be pushed into higher tax brackets as their wages rise over the next few years, and are likely to consider increasing their pension to reduce their wages and therefore their tax burden.

The latest Office of Budget Responsibility projections released with the March budget showed that between 2021/22 and 2027/28 there would be 2.1 million new higher rate taxpayers, an increase of 47%, from 4.6 million to 6.7 million.

There are also expected to be 350,000 additional new taxpayers over the same period – also a 47% increase from 650,000 to 1.1 million.

There’s a roundup of the effects of the new fiscal ‘cliff edges’ here, and This is Money editor Simon Lambert calls on the Chancellor to correct them here.

We asked a financial expert to explain what this will mean for you and others in your situation, and how to lessen the impact by making additional contributions to your pension.

There’s not long left to take advantage of it in the current tax year, which ends next Wednesday, April 5.

Richard Harwood: Pensions are a very valuable investment given the growth and non-taxable cash element, but also the ability to claim tax relief on contributions

Richard Harwood, financial planner at wealth manager RBC Brewin Dolphin, responds: Pensions are a very valuable investment given the growth and non-taxable cash element, but also, in particular, the ability to claim tax relief on pension contributions.

As you have identified, this most benefits those with an income of just over £100,000 who lose their personal allowance.

The tax-free personal allowance is reduced by £1 for every £2 of your adjusted net income over £100,000. It is effectively zero once your income exceeds £125,140.

Although income in the top bracket is taxed at 40%, the lower personal allowance means that some of your income could effectively be taxed at a staggering 60%.

In your situation, you reasonably contributed 5% of your salary to your employer’s pension scheme, reducing your income to £99,750 and keeping your personal allowance intact.

So to understand where you stand following your new pay rise, your new pay of £110,000, which equals £104,750 after your 5% pay sacrifice, effectively means that you would now be paying £1,900 in tax on the £4,750 and you would also lose £2,375 of your personal allowance.

That extra £2,375 would also be taxed at 40%, costing you an extra £950. Therefore, earning an extra £5,000 would increase your taxable income by £4,750 (after your existing pension contributions), costing you £3,325 in tax, equivalent to an effective tax rate of 60%.

One way to mitigate the so-called “60% tax trap” is to save in some form of pension.

If you paid a gross pension contribution of £5,000 your adjusted net income would fall below £100,000, restoring your personal allowance and giving an effective rate of tax relief of 60% on your pension contribution.

Of course, these numbers are based on total annual income. If you receive a raise in a tax year, the difference would not be as great.

A pay rise of £5,000 a year in September would mean your annual income increased by £2,500 during the tax year. So you may only have to contribute around that amount.

To make a difference in this tax year you will need to contribute before April 5th to reduce your earnings before the end of the tax year and if you have the funds available to make a pension contribution this should definitely worth doing. .

We have recently seen many changes to pension policy and there is now a limit of £60,000 annual pension allowance but you would be well below that with the £5250 salary sacrifice and Sipp contribution of £2,500.

Also, I’m not sure how much your overall retirement savings are worth, but there’s currently no lifetime limit to how much you can invest in a pension.

Pensions are complicated because your situation highlights and understanding the tax situation and the impact on your overall finances can be confusing, and this is where getting sound advice can help.

Typically, an advisor will take a detailed look at your financial situation and income and determine pension contributions that are appropriate for your personal circumstances.

They can also help you select the right pension fund for your needs, advise you on other tax-efficient forms of investing and keep you up to date on any changes to pension rules.