Albert Einstein reportedly said that “the hardest thing to understand in the world is the Income Tax”.
While that may be a slight exaggeration, tax rules can be difficult to understand and you may not realise that you could be likely to pay more Income Tax in coming years.
Indeed, analysis from ii shows that high earners could pay £1,905 more in “stealth taxes” over the next five years. That’s because, even though Income Tax rates did not directly increase at the beginning of the 2023/2024 tax year, a combination of frozen thresholds and increased earnings could pull you into a higher tax band.
Read on to learn more about how stealth taxes may affect you and what you can do to potentially mitigate them.
Income Tax thresholds have been frozen until the 2027/2028 tax year
The 2023 Budget did not include any changes to the rate of Income Tax, but that doesn’t necessarily mean that your Income Tax bill will stay the same. That’s because the government extended the freeze on basic- and higher-rate Income Tax thresholds until 2027/2028 having previously cut the threshold at which you start paying additional-rate tax from £150,000 to £125,140.
What this means is, if your taxable earnings increase while the thresholds stay the same or reduce, it could potentially pull you into the higher- or additional-rate tax band. This is known as “fiscal drag” and it may be more likely to affect you during a period of high inflation.
According to Office for National Statistics (ONS), inflation was 10.1% in the 12 months to March 2023. As the cost of goods and services grows, your earnings may be more likely to increase to keep up. But although an earnings increase is normally positive, it could push more of your income into a higher tax band as the thresholds are frozen.
It is important to be aware of the effect of fiscal drag because it could mean you pay significantly more Income Tax in the future, especially if you are a high earner.
High earners could pay an additional £1,905 by 2028
Figures from ii show the potential effect of fiscal drag as they estimate you could pay as much as £1,905 more in Income Tax by 2028 if you earn £50,000.
This is based on an earnings increase in line with inflation until the end of the 2023/2024 tax year, followed by a 2% increase each year until 2028. That amounts to a 21% increase in earnings but would likely cause a 35% increase in your Income Tax bill if the thresholds remained frozen.
Additionally, you risk moving into a higher tax band if your earnings increase. Indeed, Professional Adviser reports that an estimated 1.13 million people could become higher-rate taxpayers and 301,000 could be pushed into the additional-rate band by April 2028.
Although these are estimated figures, they demonstrate that even if your earnings increase, you may not benefit as much as you think because of stealth taxes.
You may also lose out if you claim Child Benefit because of the High Income Child Benefit Tax Charge.
This tax charge comes into effect for any parents earning over £50,000, and you pay tax equal to 1% of your Child Benefit for every £100 you earn over the threshold. This means that if you earn £60,000 or more, you will likely pay out as much you gain from Child Benefit.
The threshold for the High Income Child Benefit Tax Charge has not increased since its inception in 2013. However, if it had risen in line with inflation, the BBC estimates that the threshold would be closer to £65,000 in the 2023/2024 tax year and you would have to earn £78,000 to negate the benefits of Child Benefit altogether.
So, this tax charge could be more likely to affect you because the threshold has not increased while your earnings may well have done.
You may be less likely to notice these stealth taxes than you would a direct increase in the tax rate, but the effect on your bill could be just as important. That’s why you may want to consider ways to mitigate stealth taxes and make your money as tax-efficient as possible.
Increasing pension contributions may help you manage your Income Tax bill
Stealth taxes could be slowly eroding your wealth but luckily, there are ways to potentially combat them and manage your Income Tax bill.
Increasing your pension contributions, for example, may help you pay less Income Tax and boost your income in retirement. According to ii, if you earn £50,000 and see an average earnings increase of 5% over the next two years, you will then earn £55,125, with £4,855 of that being subject to higher-rate tax.
Fortunately, you can contribute that £4,855 to your pension instead, meaning that you don’t have to pay higher-rate tax on it. Additionally, you benefit from tax-relief at a rate of 40%, so it effectively “costs” you £2,913 to make that contribution.
That’s why you may want to revisit your pension contributions when your earnings increase so your money can remain as tax-efficient as possible.
Get in touch
Stealth taxes could mean that your Income Tax bill increases in the future. Fortunately, we can advise you on ways to potentially combat them.
Please contact us on firstname.lastname@example.org or call 01904 655 330. As an award-winning financial advice company that was a 2022 VouchedFor Top Rated firm, you can be sure that we’re a bona fide company providing excellent advice and high-quality service.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.