If you’re a parent of a nursery-aged child, you’ve likely received a reminder recently to confirm your eligibility for 15 or 30 hours of free childcare and tax-free childcare of up to £2,000 per year.
To qualify, parents need to have an adjusted net income of £100,000 or less. A flurry of recent news articles suggests that in a cost of living crisis, with wage-inflation and nursery fees in particular taking up a large portion of parents’ wages, an increasing number of parents are facing the unwelcome prospect of losing these benefits.
So how can you tell whether you’re on the right side of the line, and what can you do if you find you’ve edged over it?
What is adjusted net income?
This is a person’s total taxable income before personal allowances, less:
- trading losses;
- donations made through Gift Aid;
- pension contributions paid gross; and
- pension contributions where the provider has given basic rate relief.
Taxable income includes employment earnings and self-employed income, as well as savings interest, dividends and benefits in kind. From 1 April 2026, employers will be required to payroll benefits, so parents should have real time information on this element of their income. Where benefits are not payrolled, the parent will need an estimate (based on the previous year’s P60 and P11D or information from their employer) in determining their total income.
HMRC’s guidance gives examples where the parent makes private pension contributions without tax relief. These amounts can be deducted in determining the parent’s adjusted net income. But what do parents do if their pension contributions are handled by their employer by way of salary sacrifice?
Salary sacrifice pension arrangements are an agreement by the employee to receive a reduced salary in exchange for their employer making a pension contribution on their behalf. This means that the parent should take into account their reduced salary, rather than their salary as advertised. For example, a parent nominally earning a headline salary of £110,000 but who sacrifices £1,000 per month to their pension would have a salary on their P60 (and therefore an adjusted net income, assuming no other income or deductions) of £98,000, and should be able to give the eligibility declaration.
But what about the employer’s pension contribution? Ordinary benefits in kind count as part of the parent’s income for adjusted net income purposes. However, taxpayers have an annual £60,000 allowance which can be contributed tax-free into their pension, and which does not constitute taxable income. Provided the employer’s total pension contributions (including those sacrificed from the parent’s headline salary) do not exceed this allowance, the pension contributions can be ignored in determining the parent’s adjusted net income. Only above this allowance would the parent need to include the excess in their adjusted net income calculation.
Taking our example again, a parent whose headline salary is £110,000, who sacrifices £1,000 per month to their pension, and who receives a further £500 contribution to their pension from their employer would be under the £100,000 threshold (assuming no other income or deductions).
Rescuing the position
Having established the parent’s adjusted net income, what can be done if the £100,000 threshold has been exceeded? It only takes £1 over the threshold to lose the benefits outright, and an unexpected bonus or better than expected rate of savings interest during the year can make all the difference.
Parents can make a gift to charity under Gift Aid in the relevant tax year to reduce their adjusted net income below the threshold. For every £1 of Gift Aid donation, the parent may deduct £1.25 in determining their adjusted net income.
Similarly, the parent may make a post-tax contribution to their pension in order to reduce their adjusted net income. As above, they may deduct £1.25 for every £1 they contribute to their pension out of their post-tax salary.
This is especially useful where parents are a small amount over the threshold and risk losing substantial childcare benefits.
Planning ahead
Since savings interest counts towards adjusted net income, consider tax-free savings alternatives. Interest payable on ISAs is not treated as income, so parents may prefer to use ISAs to traditional interest-bearing bank accounts. Similarly, awards under Premium Bonds are not treated as income.
Married couples are able to transfer their shares between spouses on a tax-free basis. Where one parent is near the £100,000 threshold they may consider transferring any shares they hold into the name of their spouse, so that the spouse receives any dividends. Where the current shareholder is expecting to receive a relief on disposal of the shares (for example business asset disposal relief) they should take further tax advice, since the relief may not be available after the transfer to the lower-earning spouse.
Alternative incentives
Employers wishing to incentivise employee parents may be able to do so by granting them an employment-related security option. Many options, including enterprise management incentives (EMIs) and other tax-advantaged options, can be granted in such a way that no income tax liability arises at the time of grant.
When the parent chooses to exercise the option in future, the shares may generate income (either dividend income, or income on disposal), but by that time the parent may not have a need for free childcare hours, or their salary may have increased to the point where these benefits have been lost already.
Employers should be alive to the consequences of issuing shares to employee parents at a discount or for nil consideration, as the extent of the discount would be treated as employment earnings at the time of issue. That income would be included in the calculation of the parent’s net income and could inadvertently push them over the threshold and lose their entitlement to tax-free childcare.
Where employment-related securities are acquired, there is often a recommendation for the employee to enter into a section 431 or 425 ITEPA 2003 election. These elections trigger an income tax liability at the point of acquisition of the shares, in the hope that paying income tax on acquisition will result in an overall lower tax liability on future disposal (see here for more details). However, parents (especially those with multiple children claiming benefits) may find their short-term cash-flow position makes it more attractive to not elect and to suffer more tax in future on disposal etc (perhaps at a time when children are older and have lower childcare costs, or when the parent’s income is expected to have put them over the threshold and lose the benefits anyway).
Parents receiving actual shares should also note that any dividend income on the shares would count towards their adjusted net income calculation.
Timescales
The question of eligibility comes up several times during the year, so it’s worth keeping an eye on your finances even if you won’t be issued your P60 for months to come. There are still a few weeks left in the tax year to rescue your position if you’ve fallen the wrong side of the line, so hope may not be lost.