The madness of the £100,000 childcare tax trap

How could a £1 pay rise end up costing you nearly £50,000? The answer is the childcare cliff edge in the UK tax system, which will get considerably steeper for higher-earning families from September.

The government’s expansion of free childcare provision in England this autumn means that working families with children aged under three will be able to claim 30 hours of government-funded childcare a week on top of the tax-free childcare scheme. Valuable benefits, but the bulk of this entitlement is lost if one parent’s adjusted net income is more than £100,000 per year.

This threshold, introduced in 2017 when the rollout of free childcare first began, has never been increased. As “fiscal drag” takes more taxpayers over the £100,000 cliff edge, parents are finding that a small pay rise can leave them substantially worse off.

From September, a parent in London with two children at nursery who passed this point would need to earn more than £149,000 to compensate for the loss of childcare support from the state, according to new calculations by the Institute for Fiscal Studies — a pay rise of almost 50 per cent.

The yawning gulf means high-earning parents are opting to limit their earnings by reducing their working hours or making outsized pension contributions to hang on to their childcare benefits.

With hundreds of thousands more taxpayers forecast to cross the £100,000 threshold by 2028, experts warn the “behavioural response” from higher earners could have consequences for workplace productivity and economic growth — not to mention the growing complexity for families managing their finances.

Although higher earners can use various methods to stay on the right side of the cliff edge, new parents simultaneously navigating the tax and childcare systems face a steep learning curve. Many FT readers in their 30s and 40s who responded to our recent call out said they were totally unaware of the complexity awaiting them. Working out how best to manage this varies hugely between families.

FT reader Davina* works in finance, and has two children under the age of three in nursery. Although she earns a six-figure salary, it’s not high enough to compensate for the value of the childcare benefits she would lose. She has stayed under the £100,000 threshold by dropping down to a four-day week and paying her bonus into her pension.

“This year, we are £250 per month better off as a result, although I know that going part-time has affected my promotion prospects,” she says. “I feel bad for complaining, as we aren’t poor, but we’re still spending £2,750 per month on childcare even after the government help, and the reduction in my take home pay means we can’t afford holidays or a car.”

Cash flow pressures and rising mortgage rates mean some cannot afford to make outsized pension contributions to remain under the threshold.

Rob* works in tech. Since his daughter was born five years ago, he has turned down two promotions that would have taken his pay over £100,000 as he could not negotiate a high enough pay rise to compensate for the loss of childcare hours. Eventually, he quit his job and became a contractor. “This is riskier, but my earnings have jumped to the point where it is worth it,” he says. “My wife and I have decided to have no more children to maintain the quality of life we have with the one.”

From September, the expansion of free childcare in England is set to shift the financial equation again. The IFS calculates that a parent in London with two children aged under 3 at nursery would need to earn over £149,000 for their disposable income after childcare costs to be as high as one earning £99,999 (this assumes 50 hours of childcare per week at London’s median hourly cost, funded from their net pay).

Outside of the capital, where the cost of childcare is slightly lower, the IFS says the break-even point would be around £137,000 for two children receiving 40 hours of support at England’s median hourly cost.

And the situation can be even worse in other parts of the UK. In Wales the childcare threshold is based on gross salary, rather than net adjusted income, so salary sacrifice won’t help you avoid the cliff edge; in Scotland there’s no free childcare for most under 3s but no salary limit on the benefit for over 3s; and in Northern Ireland, while there are extra tax subsidies available on top of the UK-wide scheme, there is no free childcare for under 3s at all.

Freezing tax thresholds has proved a powerful way for successive chancellors to increase the tax take without altering headline tax rates. Had the childcare cliff edge risen in line with inflation since 2017, it would now be over £130,000. However, high-earning parents face a second issue, as hitting a six-figure salary is also the point in the tax system where the £12,570 tax-free personal allowance starts to be removed.

Individuals must pay a marginal rate of 60 per cent on the slice of income between £100,000 and £125,140, and 45 per cent above this level (note tax rates are higher in Scotland). This has become known as the six-figure salary trap as all too often, receiving an unexpected tax bill is how workers find out about its existence. Employees typically have to complete a tax return to pay what they owe, as it is too complex for the PAYE system to calculate and collect.

Introduced in 2010, had the £100,000 threshold increased in line with inflation it would now kick in above £150,000. Currently, 1.8mn UK taxpayers earn enough to be impacted, but as thresholds remain frozen, the IFS estimates this could increase by 20 per cent to 2.2mn in the next three years, based on its analysis of OBR forecasts.

As more taxpayers are dragged into these higher rates, the “distorting” effects of more workers attempting to avoid steep cliff edges in the system will be amplified.

Common behavioural responses of working less or limiting taxable pay stand to have a greater economic impact as more taxpayers hit these limits. As well as running counter to the government’s growth agenda, this also raises the question of how much extra tax will actually be raised.

“If people are turning away work, that’s in principle resulting in lower productivity and growth,” warns Dan Neidle, founder of the Tax Policy Associates think-tank.

“There shouldn’t be hard thresholds that radically change people’s behaviour,” he says. “The best research suggests the revenue maximising tax rate is 55 per cent. That’s very close to the current top rates of income tax plus national insurance. But the abnormally high marginal rates at £60,000 [where child benefit starts to be tapered away] and £100,000 are much higher than this.”

Increasing pension contributions is one of the easiest ways of reducing your adjusted net income (your total taxable income minus certain tax reliefs) under the £100,000 threshold. This is certainly tax efficient, but locking money up inside a pension until the age of 57 limits discretionary spending at a time when parents face multiple financial pressures.

Sean* paid £55,000 into his pension last year to stay under the threshold, leaving his family on a very tight budget. His child’s nursery has just announced it will increase fees by £1,600 a year from April, citing the impact of higher employer national insurance contributions. “It just all seems so regressive as a policy,” he says.

“At the moment, we have nothing left over at the end of the month,” says Verity*, a high earner with two children who has been making large pension contributions to stay under the threshold. “It’s like not having had a pay rise for six years when everything around you has increased; mortgage interest and monthly bills being the massive ones. On the flip side, my pension is looking pretty healthy, so I guess I’ll reap the rewards in 30 years.”

The complexity of the financial calculations involved could yet boost one area of the UK’s services economy — more parents are seeking tax advice.

“People typically want to know if there’s a magic number where it becomes worthwhile ‘pensioning down’ to reduce taxable pay,” says Philly Ponniah, a certified financial coach in London who offers group workshops and one-to-one sessions to help parents navigate the system.

The answer will depend on “a huge number of variables” including precisely how nursery fees are calculated — a dark art in itself — if student loan repayments are still being made, and whether parents can afford to pay their rent or mortgage if they increase their pension contributions.

If employers offer pension arrangements using Salary Sacrifice, it is relatively easy for workers to adjust their contributions. However, many companies only have a short “window” of a few weeks per year when changes can be made (in Ponniah’s experience, many HR departments will allow changes if staff ask nicely, but don’t want to advertise this).

Using workplace salary sacrifice schemes to buy electric vehicles, electric bikes or additional annual leave entitlement to take salaries under the threshold are all commonly used.

The situation is more complex for workers in defined benefit pension schemes. FT Money has spoken to parents working as NHS doctors who say they are turning down extra shifts to remain below the childcare threshold (see box).

Other high-earning parents in the private sector said they had become self-employed, using a limited company structure to keep salary and dividend payments under the threshold, with a view to increasing these when their child started school.

Single parents are stuck between a rock and a hard place. “You can have two people earning £60,000 a year who get everything, including full child benefit, versus one person earning £120,000 who loses their funded hours, child benefit and tax-free childcare,” Ponniah says.

Within couples, she notices that “an awful lot of people, women mostly” are squaring the circle by going part-time, or even giving up work completely. “I see a lot of female higher earners go down to four days a week, yet in many cases they still end up doing five days work,” she says.

For couples where a higher-earning partner has gone through the threshold, the size of pay rise needed to fund the additional childcare costs often exceeds the lower earner’s salary: “I encourage couples to think about childcare as a household expense, but women often feel if their salary won’t cover the childcare costs, there is no point.”

Financial planning even extends to family planning. Ponniah has noticed more professional couples are delaying trying for a second baby until their first child starts primary school. “Either they manage the childcare costs by having a bigger gap, or by just having one child. Tragically, some couples realise they’ve left it too late.”

Ahead of a challenging Spring Statement next week, tax reforms that would benefit higher earners are politically impossible for the chancellor to consider.

“The overwhelming majority of parents earn less than £100,000, and too often it’s the most disadvantaged families who miss out on the support they need,” a government spokesperson said.

“Giving every child the best start in life is central to our mission to break the unfair link between background and success — this starts with increasing access to quality early education.”

Yet the biggest problem for many high earning parents is ignorance — they simply don’t know about the tax consequences of earning a six-figure salary, so they cannot plan for it. Perhaps understandably, official government web pages do not illustrate the problems and solutions in a way that would help higher earners navigate the tax system to their advantage. But the growing impact in the workplace means that more employers are taking pre-emptive steps to educate their staff.

“Employers are definitely starting to understand what a big problem this is, especially as more younger employees enter the six-figure earnings bracket,” says Caroline Harwood, partner and national head of employment tax at BDO. She is noticing more employers proactively helping staff to manage the financial fallout, from running tax workshops to raising awareness of salary sacrifice schemes.

One senior HR leader said it would be easy for companies to crunch their payroll data and issue written alerts to staff when their earnings pass a certain point, say £90,000. She added that many firms already have similar “trigger warnings” in place for staff earning close to £200,000 who risk hitting the annual allowance taper on their pension contributions.

However, firms are extremely wary of being seen to give staff tax advice. Harwood says some are making financial advice from third-party firms available as a staff benefit. BDO has also received a record number of inquiries this year from employers who want to explore providing a workplace nursery.

Workers moving jobs are better able to argue for a pay rise. London-based lawyer Tom* has two young children, and was offered a new role on a salary of £110,000. He successfully negotiated this up to £130,000 after showing his new employer how it would impact his family financially.

He was not the only FT reader to succeed with such a tactic, however, this will only work in a limited number of professions. Far greater numbers of readers reported being hit with large tax bills after unwittingly entering the ‘trap’ or getting their calculations wrong. Teresa*, an FT reader, has had to pause her fertility treatment after a promotion at work last year took her over the £100,000 threshold: “I had no idea that my new salary was going to result in such a huge tax bill. This has had a hugely negative impact on our ability to start our family.”

The timing of bonuses, which are typically paid at the end of the tax year, makes it harder to navigate the threshold. More firms are offering staff the option to “pension their bonus” in advance, but combined pension contributions from employees and employers cannot exceed the annual allowance of £60,000 without triggering a tax charge.

The cost of scrapping the £100,000 cliff edge and making childcare support universal would likely cost in the low hundreds of millions, the IFS estimates.

As for the tapering away of the personal allowance, even if there was political desire to simplify the system for higher earners, this must be weighed against the huge amount of tax revenue being raised.

The IFS estimates that abolishing the 60 per cent rate would cost about £7bn in lost tax revenues per year, rising over time as the effects of ‘fiscal drag’ increase. However, the true cost would be lower if more higher earners responded by increasing their taxable income — through working more hours, or saving less into pensions.

A future chancellor could fund getting rid of the taper by adjusting higher rate tax thresholds to compensate. However, for this to be revenue neutral, the IFS estimates the 45 per cent tax threshold would need to be lowered from £125,140 to somewhere between £60,000 and £70,000. “The government might conclude that’s not a vote winner, and they’re better off complicating the financial lives of a smaller number of very high earners,” says Stuart Adam, senior economist at the IFS.

Neidle believes a more plausible solution would be increasing the top rate of income tax above 45 per cent, though higher earners would complain bitterly about it.

“The political cowardice of successive governments got us into this mess, with ‘tricks’ to hide the true rate of tax,” he adds. “What was initially a small anomaly has been magnified by fiscal creep into a serious problem.
Political bravery is required to tackle it. It remains to be seen if the current government are brave enough.”

*All FT reader names have been changed

All illustrations by Miss Peach.