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Budget 2021: Income tax thresholds frozen – meaning many will pay more

HMRC P60 end-of-year certificate and letters about tax rates

Some 1.3 million people are expected to start paying income tax and a million more will become higher-rate taxpayers by 2026 after Chancellor Rishi Sunak announced income tax thresholds are to be frozen after a rise this April. The Government's also freezing the pensions lifetime allowance and the thresholds for capital gains tax and inheritance tax.

While technically the Government isn't raising tax rates, its decision to freeze thresholds means many who get a wage rise – even if it's just in line with inflation – will end up paying more in income tax. Some may be drawn into a higher tax bracket (eg, some non-taxpayers may start paying 20% on a bit of income) – others may stay in the same tax bracket but will still find themselves paying a bigger proportion of their income as tax if their wages rise.

For full help on income tax and what you should be paying now, see our Income Tax Calculator.

Why freezing thresholds will lead to many paying more

Here's a summary of the income tax changes:

Income tax thresholds 2021-2026

Income tax threshold Until 6 Apr 21 From 6 Apr 21 to 5 Apr 26 
Tax-free personal allowance (20% tax applies above this threshold until you reach the higher rate below) £12,500 £12,570
Higher-rate tax threshold (i) (40% tax applies above this threshold until you reach the additional rate below) £50,000 £50,270
Additional-rate tax threshold (i) (45% tax applies above this threshold)  £150,000 £150,000

Thresholds apply UK-wide except where noted. (i) In Scotland, there are different higher and additional-rate thresholds for employees earning a salary (though these thresholds still apply for other types of income, eg, savings and dividends).

The fact that income tax thresholds will remain static after April and won't rise with inflation means as average incomes grow, many people will pay more tax – a process known in Treasury jargon as 'fiscal drag'. The Office for Budget Responsibility has published figures estimating freezes to the income tax personal allowance and higher-rate threshold for four years "will bring 1.3 million people into the tax system and create one million higher-rate taxpayers by 2025/26".

To explain exactly what 'fiscal drag' means in practice, here's MoneySavingExpert.com founder Martin Lewis: "Imagine someone who currently earns £12,000 now. Because earnings do tend to increase each year, in a couple of years' time they'll earn £13,000. But because the thresholds are frozen, they will now start to pay 20% tax on some of their earnings.

"And in fact, what freezing the threshold does is that it means no matter what you earn, as your earnings increase, a bigger proportion of your earnings goes on tax. And that's how the Chancellor makes money from it."

The upper limit for national insurance contributions is also being frozen

The Government's also said it's freezing one threshold for class 1 national insurance contributions (NICs). NICs are essentially a separate tax on income, and class 1 NICs are those paid by employees. Here's what's happening:

  • The primary threshold or lower profits limit (below which you won't pay any NICs) will rise from £9,500 now to £9,568 in April 2021. We don't know what's happening to it after that – the Government says the threshold in future will be "considered and set at future fiscal events", ie, in a major Government announcement such as the Budget.

  • The upper earnings limit or upper profits limit (the point up to which you then pay 12% NICs, and above which you pay 2%) will rise from £50,000 now to £50,270 from April 2021, but will then be frozen until April 2026.

In theory, because you pay 12% below this upper threshold and only 2% above, this change could mean some whose salaries rise with inflation pay a lower rate of NICs than they would have done if the threshold had gone up – we're checking this analysis with the Treasury, and will update this story when we hear back. However, until we know how the primary threshold will change from 2022 onwards, and what else may change, it's impossible to say for sure what the overall impact will be.

The pensions lifetime allowance, inheritance tax and capital gains tax thresholds are being frozen too

Three more key thresholds will also be frozen until 2026 – all of which will result in some paying more tax than they would have done had the thresholds risen with inflation:

  • The pensions lifetime allowance will remain at £1,073,100 until 2026. The pensions lifetime allowance is the maximum amount you can pay into your pension over your lifetime before tax is due. With this allowance frozen, it means the amount you can save tax-free will be smaller when considering the effects of inflation. There is a separate annual tax-free pensions allowance of £40,000, although this isn't changing.

  • The inheritance tax allowance will remain at £325,000 (plus an additional £175,000 to pass on your home to children or grandchildren) until 2026. Inheritance tax is a tax on the estate – so the money, possessions and property – of someone who's died. Again, if the allowance doesn't rise but the value of someone's estate does, it means it's more likely to become taxable.

  • The capital gains tax allowance will remain at £12,300/year for individuals until 2026. Capital gains tax is usually paid on any 'gain' or profit you make when you sell or dispose of assets, such as personal possessions, a second home or shares that aren't within an ISA, but you won't pay tax on gains that are less than the allowance. With the allowance frozen instead of rising with inflation, it means gains are more likely to become taxable in future.

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