Frozen tax thresholds and allowances have seen millions of households dragged into paying higher rates and more tax.
In July, Sir Keir Starmer refused to rule out extending the freeze on tax thresholds ahead of the Autumn Budget on 26 November, with many worried about how it will impact their finances.
Below, we take a look at what happens when the thresholds are frozen, who it impacts and how it can have a knock-on effect on savings and pensions.
Which tax thresholds are frozen?
There are tax thresholds which determine when people start paying income tax and NI – and how much they pay.
The freeze on income tax thresholds and NI is due to end in April 2028, but speculation is mounting that this could be extended.
The basic rate of income tax is 20 per cent, but anyone earning £50,270 to £125,140 per year becomes a higher-rate taxpayer with a 40 per cent tax rate. There is a rate of 45 per cent for additional rate taxpayers earning over £125,140.
The personal allowance – £12,570 – is the amount someone can earn before paying any tax. It used to rise every year in line with inflation, but this stopped in 2021.
The personal allowance falls by £1 for every £2 that your adjusted net income goes above £100,000. The personal allowance is zero if your income is £125,140 or above.
The impact of frozen thresholds goes beyond how much income tax people pay. People’s savings, pensions, dividends and childcare allowance can all be affected.
Tax on savings interest: For some people, frozen tax thresholds can have an impact on how much tax they pay on their savings interest.
The Personal Savings Allowance (PSA) is the amount of interest people’s savings account can earn tax-free each tax year.
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Read MoreBasic rate taxpayers can earn £1,000 in tax-free interest each year, while higher-rate taxpayers paying 40 per cent income tax can earn £500 in tax-free interest each year. Additional rate taxpayers earning over £125,140 do not get any PSA.
With tax thresholds frozen, someone who sees their pay, for example, rise from £40,000 to £52,000 per year, will suddenly find themselves paying tax on any interest on savings above the £500 mark.
Scott Gallagher, a director at wealth management firm Rowley Turton, said: “Someone on the cusp of higher rate income tax, with £25,000 on deposit, earning 4 per cent interest, or £1,000 a year, could see a £500 pay rise push them into the higher-rate band.
“That would not only cost £210 in income tax and NI, but also £200 more in tax on their savings – an effective 82 per cent rate on that pay rise.”
Sheltering savings in tax-free cash wrappers, ISAs are one option available to savers, but the annual limit is fixed at £20,000.
Tax on dividends: People who see their salaries increase may also be affected by frozen tax thresholds when it comes to how much tax they pay on dividend income – money you get from shares you have in a company.
Any dividend income over £500 is taxable. However, the amount of tax paid varies depending on which income tax threshold people are in. Basic rate taxpayers pay 8.75 per cent, while higher-rate and additional rate taxpayers pay 33.75 per cent and 39.35 per cent respectively. People can be taxed on their dividends at more than one rate.
Once a niche tax affecting a fairly small group of higher earners and business owners, it is now impacting millions of everyday investors, particularly if their salaries breach the threshold for higher or additional income tax.
Why do governments freeze thresholds?
Failing to increase the value of tax thresholds increases people’s taxable income without tax rates actually rising. This results in additional revenue for the government.
This phenomenon, known as fiscal drag, means more taxpayers are ‘dragged’ into paying tax, or paying tax at a higher rate.
While tax thresholds have remained frozen, inflation has increased, leaving people with less disposable income.
State pension and tax: There has been concern that more retirees will have to pay tax on their state pension in the coming years as a result of frozen thresholds.
The triple lock ensures the state pension increases each year in line with the highest of average earnings, inflation or 2.5 per cent.
Figures published by the Office for National Statistics this week showed that total pay, including bonuses, grew by 4.7 per cent between May and July, and so this figure will likely be used to dictate next year’s rise.
The freeze means that the state pension is on track to surpass the personal allowance for the first time in 2027.
Tax-free childcare: Workers ramping up their career and pay could see frozen tax thresholds affect their eligibility for tax-free childcare.
Eligible parents can, for example, get tax-free childcare worth up to £2,000 per child per year.
However, if someone’s adjusted net annual income is over £100,000, they lose tax-free childcare. Again, this means higher earners getting pay rises could quickly find themselves unable to apply for any tax-free childcare.
It is possible for people to reduce their total adjusted net income by, for example, adding money to pensions or making charitable donations.
Are frozen tax thresholds affecting behaviour?
Frozen tax thresholds are having an impact on how people are planning their careers and finances, according to an expert The i Paper spoke to.
Philly Ponniah, a chartered wealth planner and financial coach at Philly Financial, said: “Frozen thresholds are warping behaviour.
“I see high earners turning down pay rises, cutting back to four days a week or feeling trapped because an extra £1 can mean losing childcare hours and being taxed at an effective rate of 60 per cent.
“These freezes aren’t just raising revenue without having to announce a tax rise, they’re reshaping how people work, save and plan. The bigger risk is that the government underestimates the damage to economic output.”
She added: “Many people don’t realise that paying into a pension can bring them back below the line, keeping vital benefits while building long-term wealth.”
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