Man loses £5500 from redundancy payout after being caught by UK 'tax trap' in 'horrible anomaly'
Earning £100k might feel like a distant dream for some of us but it can quickly turn into a nightmare when it comes to an infamous 'tax threshold'.
Education around how the tax system actually works is somewhat nonexistent in schools, or maybe I just zoned out in the lessons where it was discussed, but the recently announced Budget has got a lot of us learning more about what to do with our money.
Since many of us work full-time jobs, our taxes are usually sorted through our work but self-employed folks have to sort things themselves, which is where things can quickly become confusing.
But if any of you are fortunate enough to earn triple figures, or at least close to it, you might not be surprised to hear why so many people are turning down pay rises in order to stay within a certain tax bracket.
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However, when we take into account redundancy packages, sometimes those who never thought they'd be impacted by this increased tax bracket do end up feeling short-changed.
How did a man lose £5,500 from his redundancy package?
When Clive Illenden decided to retire at the age of 57, he thought he had worked everything out from a financial point of view.
He'd worked for a large media organisation as a legal and business affairs manager for over 20 years and was due a lump sum when he took voluntary redundancy.
However, the company made it clear that his funds would be paid at the end of a financial year on 31 March, and that it could not be diluted through pension schemes.
For all his life, Clive had paid tax through the pay-as-you earn (PAYE) system, which was all sorted through his work, and he presumed that the same would be done with his final salary.
But less than a week after receiving the money, Clive was shocked to receive a £5,500 bill from HMRC, and it was only after a long conversation that he was able to comprehend why this had happened.
Clive told LADbible: “I had no idea that that you could lose your personal allowance. I took voluntary redundancy with the view that I’d be leaving at the end of the financial year. That’s what the company wanted, because they want a clean slate. I’ve been paying my taxes at normal rate. I wasn’t anywhere near 100k but I was in the 40 per cent tax rate. I knew that an element of my redundancy would be taxed but I trusted my company to do all the calculations and sort all that in my final payslip. I got the money and I had it all planned out. Literally a week later, I get a note from HMRC, who I’ve not heard from in years because I’m PAYE, saying ‘by the way you owe us £5,500’."
The 58-year-old, who lives in Berkshire, rang up HMRC thinking that they'd made a mistake but after they talked him through it, he realised what had happened.
He added: :The combination of my salary and the taxable amount of my redundancy package took me over the £100,000 for the year mark. Which meant that, in my case, I lost most of my personal tax allowance. I wasn’t earning £100k plus, so it’s not something you ever think about or consider.”
In a YouTube video, he described his own situation as a 'horrible, horrible anomaly', which threw his meticulously-planned retirement into chaos, as the financial adviser that his work had provided even missed what would happen.
Fortunately, that video did well and his subscribers have jumped up to 100k in the space of just over a year, meaning that his 'side hustle' of content creation is supporting him during his retirement.
But for many others, having their redundancy so severely taxed could throw up some serious problems, and it's worth everyone being educated on the 100k tax threshold even if you think it might never apply to you.
What is the 100k tax trap in the UK?
For many of us, the idea of earning £100k is a long way off, so we might never consider the taxes that we'd have to pay should we reach that significant sum.
Although it might seem dreamy, and it's difficult to feel sorry for people earning as much as that, Clive's story emphasises how easily the 'tax trap' can impact everyday people.
Emma McDermott, Founder at Global Tax Consulting spoke to LADbible about how the tax threshold really works and the best advice for those who are close to reaching that annual income.
She said: "The £100,000 threshold is where taxpayers start losing entitlement to their tax-free personal allowance, which is currently £12,570 at 0 per cent.
"The £100,000 allowance is measured by adjusted income which is your taxable income (so include salary, bonus, rental, dividends, interest) less relief at source pension contributions less gift aid donations.
"For every £2 of adjusted net income above £100,000, you lose £1 of your personal allowance. Once your income reaches £125,140, you've lost the allowance entirely."
So, if you're one of the many young people who have never been taught how taxes work in the UK and simply have your work sort it every month, you might not be aware that things can switch quickly when start earning a big wage.
The effective tax rate for people over 100k is 60 per cent since the income is taxed at 40 per cent, plus £1 for every £2 over £100,000 being taxed at 40 per cent, which is an effective rate of 20 per cent.
So, someone who earns £100,000 bang on would be taxed £27,432, while if you wage goes up to £110,000, those taxes will rise by a significant £6,000 to £33,432.
Therefore, Emma's best advice is to estimate and forecast what your total income will be for the tax year and make a salary sacrifice pension contribution if you're employed, or a SIPP contribution if you're self-employed, in order to bring your adjusted income to £100,000.
It doesn't just impact your income either, as high-earning parents will know that you also lose access to their 30 hours of free childcare each month should one of the parents earn over £100,000 independently.
So, the next time you get offered a big pay rise at work, which is a rare occurrence for most, maybe it's worth double-checking how it will actually impact your finances.
Topics: LADwallet
James Moorhouse