What is the Personal Allowance Trap?
What is the Personal Allowance?
Most UK taxpayers are provided a Personal allowance to reduce the income tax due on earnings. The first £12,570 of earnings are completely free from income tax. This allowance, introduced to support lower earners, is gradually reduced for higher earners. Arbitrarily, this allowance is taken away from taxpayers with income over £100,000 per year, in a move to generate more tax from higher earners.
How is the Personal Allowance reduced?
For every £2 of income received over £100,000, taxpayers will lose £1 of their £12,570 annual allowance. This means that once you are earning more than £125,140 in a tax year, you completely lose your personal allowance. Incidentally, earnings above this amount are also liable to additional rate tax.
Who is affected by the Personal Allowance Trap?
This rule has a significant negative impact on taxpayers earning between £100,000 and £125,140. Each pound of their Personal Allowance lost is liable to 20% income tax, in addition to the normal rate of income tax paid of 40%. They are then in effect taxed at 60% on earnings between £100,000 and £125,140. This seems quite punitive as taxpayers with earnings over £125,140 are taxed at the lower 45% rate for additional rate taxpayers.
This 60% effective tax rate is referred to as the ‘Personal Allowance Trap’.
How do I avoid the Personal Allowance Trap?
Thankfully, there are a number of tactics used to mitigate this quirk in the system, mostly by reduction of a taxpayers ‘Adjusted Net Income’. In simple terms, Adjusted Net Income is arrived at by taking a taxpayer’s income for a given tax year less trading losses, contributions to charities and contributions to pensions.
For taxpayers looking to escape the Personal Allowance Trap, the objective is to bring their Adjusted Net Income below £100,000, therefore retaining their personal allowance. This can be done by making additional pension contributions and donations to UK registered charities which provides Gift Aid relief. Contributions in most instances can be ‘Grossed up’, providing an additional reduction.
What is Salary Sacrifice?
Another method for reducing your Adjusted Net Income is the use of ‘Salary Sacrifice’. This is an agreement with your employer to exchange part of your salary to be paid as additional pension contributions, rather than income. There are benefits here for employers as they can reduce the National Insurance paid on income. More generous employers will even pass this saving onto the employee by way of additional pension contributions.
We have a separate page explaining Salary Sacrifice in more detail, which can be found here.
Avoiding the Personal Allowance Trap in practice
Let’s work through an example together:
Jennifer earns £125,000, as a result her earnings of £25,000 are in the Personal Allowance Trap and liable to an effective 60% tax rate.
If her employer permits, she can make use of a Salary Sacrifice arrangement. She could exchange £25,000 of her salary to be made as an additional pension contribution, reducing her income down to £100,000.
By doing so, she reclaims £12,500 of her personal allowance. Where previously the first £70 of her earnings were tax free, now £12,570 goes to her pocket.
Overall, her income tax liability falls from £42,432 down to £27,432, a £15,000 saving.
In this simple example we’ve not covered the savings made by this arrangement for National Insurance purposes, though there are savings for both the employer and employee in Salary Sacrifice arrangements.
Drawbacks of Salary Sacrifice
There are some drawbacks for those that opt into a salary sacrifice arrangement, principally the funds sacrificed are now held within a pension, which may pose a problem for younger taxpayers. You should also consider that your salary is reduced for the purposes of borrowing, which may pose a problem if you’re applying for a mortgage.
Get in touch
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No financial decisions should be taken based on the content of this website or associated videos. The guidance contained within this website is subject to the UK regulatory regime and is therefore primarily aimed at viewers in the UK. Always take full individual advice first. Regulations and legislation governing taxation, investments and pensions may change in the future.
The content on this page is accurate as of the 2024-25 tax year.