Tax system means workers could be left with just £6.50 from a £1,000 pay rise

AJ Bell press comment – 1 December 2022

• The convoluted UK tax system means many people are left with tiny sums after a pay rise
• A high earner with student loans will get just £6.50 in their pocket after a £1,000 pay rise – a 99% tax rate
• Parents hitting the £100,000 threshold for tax-free childcare could lose more than their £1,000 pay rise
• A middle-earning parent-of-three repaying student loans will be hit with an 85% tax rate
• Using salary sacrifice can boost your savings and dramatically cut tax bills at the same time

Families and high earners face eye-watering tax rates leaving some with just a few pounds from a £1,000 pay increase, new analysis from AJ Bell shows.

The complicated mesh of thresholds and allowances, most of which have been frozen under the Chancellor’s deep freeze on personal taxation, means that some workers getting a £1,000 pay rise will lose almost all of it through tapered benefits or cliff-edge allowances, while those who have student loans will be hit with extra deductions on top.

In the most extreme cases some people will be left with just a few pounds from a £1,000 pay increase. Some will need to divert money into their pensions to avoid a tax penalty bigger than the pay increase.

Some of the worst affected are higher earning graduates. A graduate with a student loan receiving a pay increase next year pushing them into the additional rate tax bracket, which will be lowered to £125,140, could be left with just £6.50 in take home pay after a £1,000 pay increase. This also takes into account losing the Personal Savings Allowance - the tax break on savings interest.

Parents seeing Child Benefit tapered because they earn over £50,000, or losing Tax-Free Childcare completely once their earnings exceed £100,000, will also be hit by sky-high effective marginal tax rates.

Laura Suter, head of personal finance at AJ Bell, comments:

“The fact that someone can end up with £6.50 in their pocket after getting a £1,000 pay rise shows just how complicated and confusing our tax system has become. Rather than having a neat system of taxation that everyone can understand, we’ve got a jumbled mess of different tax rates left by successive Governments.

“What’s worse is that most taxpayer won’t be aware of the bizarre array of different allowances and rates, meaning they will be chuffed with a pay rise and won’t realise the sting in the tail that’s coming.

“The worst offenders are cliff-edge allowances, like tax-free childcare, where you lose the entire perk when you earn £1 over the threshold. This leaves workers in the mind-boggling situation where they could be better off turning down a decent pay rise as they’ll lose more in Government support than they stand to gain.

"Anyone in this situation can make use of salary sacrifice to get their salary below these crucial thresholds. The most popular option is using salary sacrifice to put money in your pension, meaning that putting a small amount extra in your pension could bring you back under the limits. It means that people need to be able to afford to put the money in their pension, but once you've taken into account the high marginal tax rates, it could cost you very little.

“The UK’s tax system is crying out for an overhaul and simplification, so that workers can understand exactly what they’ll be taking home and where a pay rise will actually mean they end up substantially better off. Sadly, the recent scrapping of the Office for Tax Simplification seems to signal that this isn’t a top priority for the current Government.”

Some of the worst effective marginal tax rates explained

•           High-earning graduate with cash savings income - £6.50 from a £1,000 pay rise

“The system means that a graduate on £124,150 who gets a £1,000 pay rise will keep just £6.50 of that money – an effective 99% tax rate (see graphic above). That’s because they’ll be subject to the Personal Allowance taper, where you lose your tax-free earnings allowance, giving an effective tax rate of 60%. On top of that if they have a student loan (plan 2) they will repay 9% of their income over £27,295 and those with a post-graduate loan will repay an extra 6% of their income over the threshold of £21,000.

“On top of this, from next April someone earning more than £125,140 will be an additional-rate taxpayer, meaning they lose their Personal Savings Allowance. This gives a £1,000 tax-free allowance for basic-rate taxpayers and £500 for higher-rate payers, but nothing for additional-rate taxpayers. It means they will face 45% interest on the £500 of savings interest that previously was covered by the allowance, meaning an extra £225 in tax.”

•           Middle-earning parents with a student loan - £151 from a £1,000 pay rise

“Parents are also hit by the withdrawal of allowances for children when they hit certain income levels. A parent-of-three earning £51,000 who is repaying a student loan will face an 85% effective tax rate on a £1,000 pay rise. They will face higher rate income tax, National Insurance and student loan repayments, but will also be subject to the Child Benefit High Income Charge. This means they lose 1% of their child benefit payments for every £100 they earn over £50,000. For three children that 10% loss for a £1,000 pay rise equals £339. It means they take home just £151 of their £1,000 pay rise.”

•           High-earning parent – worse-off from a £1,000 pay rise

“Someone who hits the earnings limit for Tax-free Childcare sees a bigger tax hit than their pay rise is worth. Tax-Free Childcare gives parents £2,000 towards their childcare costs, but once one parent earns more than £100,000 they lose the entire benefit. It means a graduate earning £99,999 who gets a £1,000 pay rise will be subject to the Personal Allowance taper and student loan repayments, but will also lose their £2,000 Tax-Free Childcare. This means the £1,000 pay rise actually leaves them £1,710 worse off – so they would be better off putting the pay rise into their pension to boost their savings and retain access to the Tax Free Childcare scheme.”

Source: AJ Bell