Keith Brooks

With the start of a new tax year, it’s time to look at your tax affairs and whether you are paying an appropriate amount in line with your earnings – particularly with even more changes introduced following last year’s Scottish Budget. It saw the introduction of a new ‘advanced’ rate for those earning between £75,001 and £125,140, as well as freezes to some thresholds, dragging more people into paying higher rates of tax.

On the face of it, you might think the highest rate of income tax in Scotland is 48% for those earning more than £125,140 per year. However, the reality is that for anyone with earnings between £100,000 and £125,140 their effective tax rate is 70% - 69.5% to be exact – on this portion of their income, including National Insurance contributions, meaning they keep just 30p in every £1 earned.

The reason for this is the way the tax-free personal allowance is treated. Most people have a standard personal allowance of £12,570 – the amount of income you are allowed to earn before paying tax each year. If you have a standard personal allowance, the tax rates you pay for each band of earnings are: 0% on income up to £12,570, 19% to £14,876, 20% to £26,561, 21% to 43,662, 42% to £75,000, 45% to £125,140, and 48% from £125,140.

Once you earn more than £100,000, your tax-free personal allowance starts to be tapered, reducing by £1 for every £2 that your income exceeds £100,000. If your income is £125,140 or more, you end up with no tax-free personal allowance. The result of this means a Scottish taxpayer earning between these two figures faces an effective rate of 70% on that £25,140 of income.

For someone earning £110,000, you would not only pay £4,500 in advanced rate tax on the top £10,000 of your income, you would also lose £5,000 of your personal allowance. And, with £5,000 of your personal allowance gone, that portion of your income is now also subject to tax at 45%, costing you another £2,250. When you factor in national insurance at 2% it leaves just £3,050 from that original £10,000, giving an effective tax rate of 70%

Saving into a pension is one of the most straightforward ways of mitigating against this tax trap. If you earn £110,000 and make a gross contribution of £10,000, your adjusted net income would fall to £100,000. Doing this would reinstate your full personal allowance and provide an effective rate of tax relief of 69.5% on your pension contribution, while also boosting your pension pot for the long term through the power of compounded returns.

However, bear in mind that there is a cap on the amount you and your employer can pay into your pension each year and still receive tax relief. For most people, the pension annual allowance is 100% of your UK earnings or £60,000, whichever is lower. This might be tapered if your adjusted income exceeds £260,000.

If you exceed your annual allowance, you’ll have to pay an annual allowance charge, which essentially claws back any tax relief received on the excess contribution. If you aren’t sure how much your annual allowance is, or you’re concerned about exceeding it, speak to a financial or tax adviser.

Keith Brooks is financial planner at wealth manager RBC Brewin Dolphin