Until children reach school age, it may be especially worthwhile to prioritise pensions over salary.
Regular readers will be aware of the 60% tax trap on income between £100,000 and £125,140 due to the loss of the tax-free Personal Allowance (click here for a blog on this very topic).
But for parents of young children, the real tax rate can be much higher – in some cases, well over 100% (i.e. your take-home pay will actually decline as income breaches the £100k threshold). This is due to the loss of entitlement to tax-free childcare and free childcare hours.
The current (and proposed) rules
To help with the costs of childcare, most parents are eligible for tax-free childcare and free childcare hours:
Tax-free childcare
You can get £500 every 3 months (up to £2,000 a year) for each child to help with the costs of childcare. This goes up to £1,000 every 3 months if your child is disabled.
It’s easy to set up – you open a government childcare account online (link here) and for every £8 you pay in, the government will credit the account with £2. The money can then be used to pay for ‘approved childcare’, e.g. nurseries, nannies, after-school clubs, etc.
In terms of eligibility:
- Your child must be 11 or under,
- You and your partner (if you have one) must each be working 16 hours per week and earning at least the National Minimum Wage on average,
- However, if either of you has ‘adjusted net income’ over £100,000, you will not be eligible.
Free childcare hours
All 3 and 4-year-olds get 15 hours of free childcare per week during term time (i.e. 38 weeks a year), regardless of their parents’ earnings. This is known as the ‘universal hours’.
The allowance goes up to 30 hours for ‘eligible working parents’. However, like tax-free childcare, the extra hours are lost if either parent has an adjusted net income above £100,000.
These rules are due to change:
- From April 2024, working parents of two-year-olds will be able to access 15 hours of free childcare,
- From September 2024, 15 hours of free childcare will be extended to all children from the age of nine months,
- From September 2025, working parents of children under the age of 5 will be entitled to 30 hours of free childcare per week.
My understanding is that the new rules (i.e. those impacting children under the age of 3, to be introduced from April) will adopt the same eligibility criteria as the current ‘extra hours’ rules for 3-4-year-olds.
Or put another way, if you or your partner has adjusted net income above £100,000, you won’t be entitled to any of the extra free hours, only the 15 universal hours for 3-4-year-olds.
The £100k cliff-edge
Unlike the gradual loss of Personal Allowance, the loss of childcare is a cliff-edge – earning £1 over £100,000 can cost 15 hours of free childcare and up to £2,000 tax-free childcare per child (under the current rules).
The result is that the marginal tax rate for parents of young children earning just above this threshold is shocking.
This is best demonstrated by way of an example:
Example
- James and Juliet are married with two children, aged 1 and 3.
- Juliet is the higher earner of the two and currently has an adjusted net income of exactly £100k a year.
- Both children are at nursery 8am-5pm, 4 days a week, at £6.70 per hour / £241 per week each (in line with the UK average).
- At present, James and Juliet are making full use of the available £2,000 tax-free childcare for their youngest child. Whereas the eldest child is entitled to 30 hours of free childcare for 38 weeks of the year, worth £7,638 pa. They receive a further £980 tax-free childcare to put towards the remaining cost.
- Say Juliet receives a 5% pay rise, taking her adjusted net income to £105k.
- Factoring in the loss of her Personal Allowance, she will incur additional income tax and National Insurance contributions of £3,100.
- But this pay rise will also cost the family 15 hours of free childcare, at an annual cost of £3,819, and all of their tax-free childcare, worth £2,980.
- As such, the net effect of the £5,000 pay rise is an increase in take-home pay by ‘just’ £1,900 (£5,000 - £3,100 tax and NICs), but an accompanying rise in childcare costs by £6,799 (15 free hours plus 100% tax-free childcare allowance).
- James and Juliet are effectively worse off to the tune of £4,899, an effective 198% tax rate on the salary increase.
Disclaimer: The Financial Conduct Authority does not regulate tax advice. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts and their value depends on the individual circumstances of each investor.
Pensions to the rescue
The good news is that pension contributions can be used to reduce adjusted net income, on which, the tax-free childcare and free childcare hours are based. This can be done either through your workplace (salary sacrifice), or by making a personal contribution directly into your pension scheme.
In the example above, if Juliet were to direct 100% of her pay rise into a pension, she would receive an effective 60% income tax relief on contribution, plus 2% NI saving (assuming this is done via salary sacrifice), and also retain entitlement to tax-free childcare and the free childcare hours.
The previous marginal tax rate (198%) is equivalent to the effective tax relief on pension contribution – a ‘no brainer’ in most instances.
The key point here is that, until children reach school age, it may be worthwhile to prioritise pensions over salary – the maths are phenomenal and you’d potentially be ‘better off’ (in terms of the money in your back pocket) whilst also boosting your pension savings.
Disclaimer: A pension is a long-term investment and funds are not normally accessible until 55 (rising to 57 from April 2028). When investing via a pension, your capital is at risk. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require in order to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
