A pay rise is supposed to be good news. But in the UK’s increasingly complex tax system, earning more can sometimes leave you with less cash in your pocket, as silly as that sounds.
Olly Cheng, financial planning lead at Rathbones, says: “A new tax year usually brings a clean slate, but this one marks a clear step up in so called stealth taxes. Frozen thresholds are quietly pulling more people into higher tax bands, meaning more households will pay more tax, often without realising it.”
Worse still, benefit cut-offs mean some workers face so-called cliff edges – points where earning more money triggers not just higher tax payments, but also the loss of valuable support.
However, that doesn’t mean you should turn down a pay rise. With the right planning, you can keep more of your money – and in many cases, still come out ahead.
The problem with pay rises
According to the Office for National Statistics, regular pay grew by 3.6 per cent in the three months to February of this year, with total earnings including bonuses up 3.8 per cent.
While rising wages may sound positive, they are increasingly pulling more people into higher tax brackets – a phenomenon known as fiscal drag.
Tax thresholds have been frozen since 2021 and are now set to remain in place until April 2031, meaning more workers are being caught by higher rates as their pay rises.
Key thresholds to watch out for
There are several key points in the income scale where earning more can trigger higher taxes or the loss of some kind of benefit.
At £12,570 – the point at which you start paying income tax – some valuable perks begin to disappear. The 0 per cent starting rate for savings, which allows up to £5,000 of savings interest to be tax-free, starts to taper away. Eligibility for the marriage allowance (up to £252 a year) also ends once you become a basic-rate taxpayer.
Further up, graduates start repaying student loans once earnings reach £25,000 or £29,385, depending on their loan plan. At £50,270, workers enter the higher-rate (40 per cent) tax band, with allowances for savings reduced and taxes on investments increased.
The impact becomes more significant at £60,000, where child benefit begins to be withdrawn, potentially costing families more than £2,200 a year.
One of the sharpest cliff edges comes at £100,000, where people start to lose their personal allowance and, for parents, access to childcare support. At £125,140, the personal allowance is lost entirely and the additional rate of 45 per cent income tax applies.
Why you should still take the pay rise
Despite these pitfalls, turning down a pay rise is rarely the right move. Higher earnings still increase your long-term financial position, particularly when it comes to pension contributions, career progression and future salary negotiations.
A higher salary today can also lead to larger pay rises in the future, as increases are often percentage-based: a 5 per cent rise on a £30,000 salary is £1,250, giving you £31,500 as a new salary, but a 5 per cent rise from that total is £1,575, and so on.
The key is not to avoid earning more, but to manage how that income is taxed.
Many of the strategies that keep you below thresholds don’t mean losing the value of your pay rise – they simply shift when you receive it.
Use your pension to stay below thresholds
One of the most effective ways to reduce the impact of moving into a different tax band is through pension contributions.
“Pensions are your friend in this situation, as paying into a pension can reduce your taxable income and bring you back below many of these thresholds – meaning you either pay lower tax rates or you get back benefits that would have been lost,” says Laura Suter, director of personal finance at AJ Bell.
Importantly, paying into your pension does not mean you are losing money.
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Instead, you are redirecting part of your income to a tax-efficient place where it can grow over time. You may not have access to it immediately, but you are effectively paying yourself in the future – with the added benefit of tax relief and potential investment gains.
Many employers match pension contributions up to a certain level. In effect, this is free money that compounds over decades.
Salary sacrifice can help too
Another way to manage your taxable income is through any salary sacrifice schemes offered by your employer.
These arrangements allow you to exchange part of your salary for certain benefits, before tax is calculated. This reduces your adjusted net income and may help you stay below tax band thresholds.
Common salary sacrifice schemes include cycle-to-work schemes, electric car leases, additional annual leave purchase, and some health or wellbeing benefits.
Protect your investments with an ISA
Once you become a higher-rate taxpayer, your personal savings allowance is reduced from £1,000 to £500.
The amount of dividend tax you’ll need to pay goes up too.
Basic-rate dividends are taxed at 10.75 per cent, higher-rate dividends at 35.75 per cent and additional-rate at 39.35 per cent.
The dividend tax-free allowance now stands at just £500 a year, down from £5,000 a decade ago.
One of the simplest ways to reduce this tax burden is by using an Individual Savings Account (ISA), which allows you to save or invest up to £20,000 a year with returns free from income tax, dividend tax and capital gains tax.
Camilla Esmund, senior manager at interactive investor, adds: “For spouses and couples, you can make use of both £20,000 annual ISA allowances, meaning you have a £40,000 allowance to play with.”
When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
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