UK tax and frozen allowances
UK income tax thresholds are currently frozen until at least 5 April 2028, with many anticipating this will be extended in the Autumn unless there is an unexpected improvement to Government finances.
Freezing tax thresholds is often referred to as a stealth tax, as it has proven a useful way for successive Governments to increase tax revenue without generating much public backlash.
As inflation, wages and asset prices have consistently risen, many pay more tax than ever before. However, it can be possible to significantly reduce the tax burden through pension contributions.
Restoring the Personal Allowance
The tax-free personal allowance is reduced by £1 for every £2 earned over £100,000, until the personal allowance reduces to zero. This had the effect of creating an effective 60% marginal tax rate for people earning above this level, dropping to 45% once the personal allowance is fully eroded.
The personal allowance is currently frozen at £12,570 until 6 April 2028, meaning that those earning between £100,000 and £125,140 per year are paying the 60% marginal tax rate.
Example – Liam
Liam lives in England, earning £125,000 per year. His Personal Allowance is reduced
by £12,500 (£25,000 / 2) to £70. His income tax calculation is as follows:
Gross Income Tax Net Income
Personal Allowance £70 £0 £70
Basic Rate £37,700 -£7,540 £30,160
Higher Rate £87,230 -£34,892 £52,338
Total £125,000 -£42,432 £82,568
Liam is concerned about the high rates of tax he is paying. His adviser suggests that he considers making a pension contribution of £25,000.
He pays £20,000 to a relief at source scheme, where 20% basic rate tax relief is added,
resulting in a £25,000 (£20,000 / 0.8) gross contribution.
As Liam is a higher rate (40%) taxpayer, he is due a further 20% tax relief. This is applied by extending his basic rate tax band by the amount of the gross pension contribution (£37,700 + £25,000 = £62,700). In addition, his gross income is now reduced to £100,000, so his personal allowance is restored in full. His new income tax position is as follows:
Gross Income Tax Net Income
Personal Allowance £12,570 £0 £12,570
Basic Rate £62,700 -£12,540 £50,160
Higher Rate £49,730 -£19,892 £29,838
Pension Contribution -£25,000 £5,000 -£20,000
Total £100,000 -£27,432 £72,568
Liam has paid £25,000 into his pension fund but has only seen his net income reduce by £10,000 (£82,568 – £72,568). This means Liam has received effective tax relief at a rate of 60%.
For simplicity, the above example doesn’t include national insurance contributions (NICs). However, if the contribution could be made using salary sacrifice, Liam’s reduced NICs would mean that he gets an even higher rate of tax relief (which could be extended further if Liam benefits from any of his employers’ NIC savings).
Using pension contributions to restore the personal allowance can be one of the most tax efficient ways to save.