Pensions can be a secret weapon to save parents from tax traps, helping them hang onto cash and childcare.
As your income creeps up, the tax man doesn’t just take a bigger cut in income tax. The government also starts clawing back everything from Child Benefit, tax-free childcare and free childcare hours to your tax-free personal allowance.
Suddenly, you face losing thousands of pounds more than the standard rates of income tax, and it hits parents particularly hard. Nowadays, more people than ever before are likely to get caught by tax traps, because the thresholds when people start paying different rates of tax have been frozen since April 2021. As salaries rise, more and more families are pushed into paying higher rates of tax – and lose out on help with their children.
Keen to stop this from happening? It may be worth considering paying more into your pension.
This works because your eligibility for several allowances and benefits is based on your income after deducting pension payments and donations to charity. Pension payments reduce your ‘adjusted net income’ and can therefore help cut your tax bill and hang onto financial benefits and childcare.
If your employer offers it, you could opt for salary sacrifice instead, where you swap some of your salary for perks such as higher pension payments, which also reduces your taxable income.
For the tax year 2024/25, most people are allowed to pay up to £60,000 or 100% of their earnings into a pension. This provides quite a lot of leeway to bump up your retirement savings, cut your tax bill and potentially keep your childcare.
Here are four of the tax traps pensions can help you escape.
1. Higher rate tax trap
When your annual income tips over £50,270 (for the tax year 2024/25), you face paying twice as much income tax on the extra, as your tax rate shoots up from 20% to 40%.
But if you pay more into your pension, bringing your ‘adjusted net income’ below £50,270, you can avoid paying higher rate tax.
2. Child Benefit trap
Once you or your partner earn over £60,000 a year (for the tax year 2024/25), the tax man starts taking back 1% of your Child Benefit for every £200 over the threshold. It’s known as the ‘High Income Child Benefit Charge‘, and means you’ll lose all your Child Benefit once the higher earner brings in more than £80,000 (for the tax year 2024/25).
For a family with two children under 16, or under 20 and in full-time education, that means missing out on more than £550 a year (for the 2024/25 tax year).
Yet if you pay more into your pension, and bring down your ‘adjusted net income’ closer to £60,000, you can hang onto more Child Benefit. As an added bonus, you’ll also pay less in higher rate income tax.
3. Childcare and personal allowance trap
If you or your partner earn over £100,000 a year, families face a damaging triple whammy.
You suddenly lose out on the Tax-Free Childcare scheme. For the tax year 2024/25, this is worth up to £2,000 a year per child (or £4,000 for a disabled child) towards childcare costs such as nurseries, childminders and some summer camps.
Plus, parents in England are no longer entitled to free childcare hours, whether 15 hours a week for children aged 9 months to 2 years, or up to 30 hours a week for children who are 3 to 4 years old. These free hours can be worth thousands of pounds a year. Details of free childcare vary in Wales, Scotland and Northern Ireland so it’s worth checking the rules and your eligibility.
You also face paying extra income tax, because for every £2 you earn over £100,000 a year, you lose £1 of your £12,570 tax-free allowance. By the time you earn £125,140 a year or more, your personal allowance has been wiped out completely.
By upping pension contributions, so ‘adjusted net income’ for each parent dips below the £100,000 a year cliff edge, families can keep their entitlement to tax-free childcare, free childcare hours and their tax-free Personal Allowance.
4. Additional rate tax trap
Once your income tops £125,140, it triggers a 45% tax bill on the extra. Again, pension payments can ride to the rescue, pushing down income after pension contributions so you pay less additional rate income tax.
Faith Archer is a Personal Finance Journalist and Money Blogger at Much More With Less. Check out Faith’s YouTube series about retirement planning.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
