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A secret tax grab - and how to beat it with your pension

Ed Monk

Ed Monk - Fidelity International

Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

You might not have noticed the news that you may soon be paying more tax on the money you earn.

There has been no announcement of an increase to current rates of tax, or to the thresholds at which those rates start to be paid.

Instead, what we’ve got - announced in the March Budget - is a freezing of some income tax bands for the rest of this Parliament. It means that, instead of rising with inflation, the thresholds for both the Income Tax Personal Allowance - when 20% tax begins - and the higher-rate threshold - when 40% tax begins - will remain where they are for the next four years.

Meanwhile, of course, the wages earned by workers will hopefully rise. As a result, a greater number of people will see their earnings in the next few years rise above a new tax threshold, and they will pay a higher amount of tax on money earned above that level.

It may sound like a small change given that tax bands were only due to rise by the rate of inflation, but it will make a difference to a lot of people. The Office for Budget Responsibility has said freezing the tax bands will push an extra one million people into paying higher rate tax1, while the government will collect an extra £8 billion in tax over the four years that the freeze remains in place.

To see the effect of the change, it’s worth seeing what would happen if tax bands rose as previously planned. At the moment, workers pay no Income Tax on the first £12,570 they earn. Earnings above that level are then subject to 20% tax until the higher-rate 40% band begins for earnings above £50,270. Additional Rate 45% tax then begins when earnings hit £150,000.

The table below shows the situation for people earning at three levels near to the current higher-rate tax threshold. In each case, they would not face paying any higher rate tax in four years’ time if the threshold were to rise in line with inflation, which we’ve assumed to be 2%. With the threshold frozen, however, each of them faces seeing their earnings trip over into the higher-rate band, triggering an extra amount of tax.

Annual earnings today Annual earnings in four years if rising with inflation (2%) Higher rate threshold in four years if raised with 2% inflation Higher-rate threshold if frozen at level today Extra tax due
£46,500 £50,333 £54,414 £50,270 £12.62
£48,000 £51,957 £54,414 £50,270 £337.35
£50,000 £54,122 £54,414 £50,270 £770.32

Source: Fidelity International, April 2021

Pensions - a powerful weapon against a tax-band freeze

There are few benefits to paying a higher rate of tax, but one is that you might be able to benefit more from the system of tax relief on pensions.

The system applies tax relief at your highest marginal rate. When you pay money into a pension a boost equivalent to any basic-rate tax paid is automatic, while the extra available to higher and additional rate payers is either added automatically or else claimed through a self-assessment tax return. Contributions are allowed to build tax-free and then 25% of the pot can normally be taken from age 55 with no tax due and income tax payable on the rest. A good way to look at it is that it costs a basic-rate payer £80 to make a £100 pension contribution under the current rules, while a higher-rate taxpayer pays just £60 for the same effect and an additional-rate taxpayer £55.

The biggest relative benefit comes for those whose income in retirement puts them in a lower tax band than was the case during their working life and, because the system is linked to the income tax you pay, it is more generous overall to higher earners.

So, if you slip into the higher-rate band over the next few years you can get a higher rate of tax relief on any pension contributions you make. That is worth bearing in mind if you see your earnings rise above a new tax threshold. You may wish to divert a bit more from earnings into your pension to ensure you keep it all.

If you work for an employer which offers a workplace scheme you should consider looking to maximise any offer they make to match your pension contributions. Bringing your pensions together also allows you to view all your pension savings in once place, with thousands of investment options for you to choose between. If you need help bringing your pensions together, there’s guidance to help you find the right home for your retirement money. You’ll have total control and will be able to keep tabs on the progress you’re making towards your retirement goals.


1 - Office for Budget Responsibility, March 2021.

Important Information: Withdrawals from a pension product will not normally be possible until you reach age 55. Tax treatment depends on individual circumstances and all tax rules may change in the future. This information and our guidance tools are not a personal recommendation for any particular investment. You should regularly reassess the suitability of your investments to ensure they continue to meet your attitude to risk and investment goals. It’s important to understand that pension transfers are a complex area and may not be suitable for everyone. Before going ahead with a pension transfer, we strongly recommend that you undertake a full comparison of the benefits, charges and features offered. To find out what else you should consider before transferring, please read our transfer factsheet. If you are in any doubt whether or not a pension transfer is suitable for your circumstances, we strongly recommend that you seek advice from an authorised financial adviser.