How to pay less tax: high earners
With the country in the grip of austerity measures, you can be sure that most of us will see our tax bill rise in April. But, while some of it's unavoidable, there are steps you can take to ensure you don't hand over more than you need to.
Tax rises will see the taxman receiving much more of every pound you earn. As an example, if you're a basic-rate taxpayer, for every £1 you earn over the £7,475 personal allowance, the taxman will get 20p in income tax.
On top of that, HM Revenue & Customs (HMRC) will receive 12p in employee national insurance and a further 13.8p in employer national insurance. That's a total of 45.8p so far for the taxman, 32p of which has come out of your pocket.
Then, if you spend the 68p you have left on something that's subject to VAT, HMRC will get a further 11.3p. This means the taxman could end up taking 57.1p of every £1 you earn.
Simply refusing to pay tax isn't possible without breaking the law, but figures from professional advice website unbiased.co.uk show we're wasting billions of pounds in unnecessary tax. This includes £328 million in income tax; £552 million in capital gains tax; almost £2 billion in inheritance tax (IHT); and £3.9 billion in unclaimed child and pension credits.
The average UK taxpayer wastes an estimated £186 a year in unnecessary tax payments.
In the third part of our series, we show higher-rate tax payers how to keep as much of your money as possible in your pocket and out of the taxman's clutches.
Case study: A high earner looking to the future
Max Mitchell, a 41-year-old solicitor, is feeling the squeeze on high earners. He earns £140,000 and will see his net pay drop by £1,501.44 this year as a result of changes in tax and national insurance.
However, while Max is taking less money home, there are a number of tax breaks he can take advantage of to make up for it.
Stephen Herring, senior tax partner at BDO, says Max should look closely at his pension. "The anti-forestalling rules have restricted many people's pension contributions to £20,000, but the new carry-forward rules, coupled with the £50,000 annual pension limit, mean he could pay in £110,000 in the 2011/12 tax year - £50,000 for the year plus two lots of up to £30,000 of unused allowance from the two previous years," he says.
Although it may be worth playing catch-up with his pension, Herring recommends caution: "The lifetime limit is dropping from £1.8 million to £1.5 million from April 2012, with any excess hit with an effective tax charge of 55%.
"If you think your fund will grow to more than £1.5 million by the time you retire, you can elect to freeze contributions after April 2012."
As an alternative, or in addition, Max could consider tax-efficient investments. ISAs are a good starting point, but he could also consider a venture capital trust (VCT) or an enterprise investment scheme (EIS) as both offer generous tax breaks.
From an income-tax perspective, a VCT gives you 30% relief on investments up to £200,000, while an EIS provides 20% relief on investments up to £500,000; but you need to hold them for at least five and three years respectively. This means that if Max pays £20,000 into a VCT, he'll get £6,000 to offset against his income tax bill.
On top of that, neither are liable for capital gains tax (CGT) (subject to three-year holding for EIS): VCTs pay dividends tax-free and EISs are exempt from inheritance tax after two years.
But Herring warns against focusing solely on the tax breaks: "They are there to channel money into higher-risk trading businesses. Max should make sure what he gains in tax relief isn't swallowed up by poor performance."
More generally, if capital gains on his investments are an issue, Herring recommends Max sells assets each year to make sure he doesn't go over the annual CGT allowance (£10,100 in 2010/11).
Getting the basics right
While complex planning can save you thousands in tax, it's also worth paying attention to the basics such as your tax code and tax credits. This guide will help you get the basics right.
• Check your tax code by looking at your pay slip or asking your tax office for a coding notice. This will detail your allowances and any deductions due to state benefits or taxable employee benefits.
If it doesn't look right, query it - any errors will affect how much you pay or potentially result in a large tax demand if you're paying too little.
Given the size of most of our tax bills, it's probably no surprise that some of us pay too much. This can happen if you change jobs and your correct tax code isn't used, or if you have more than one job. If the overpayment relates to the current tax year, contact your tax office as it'll be able to adjust your tax code.
If an overpayment relates to a previous year, write to your tax office with your P60 and details of your income. You can claim back overpaid tax for up to six years, although this is reducing to four years in April 2012.
• You can also pay too much tax on your savings as tax on interest is deducted at source. If this has happened, complete a form R40 Tax Repayment Form for each year you've paid too much. A form R85 from your building society or bank will stop future interest being taxed.
• Another basic that can affect your overall financial position is tax credits. Nine out of 10 families with children are entitled to tax credits and any pensioner receiving less than £137.35 a week (£209.70 for couples) can get pension credit. A benefit-checker such as that provided by Turn2us can help you claim your entitlement (turn2us.org.uk).
April 2011 - the key changes
Tax rates remain the same but there's an increase in the personal allowance from £6,475 to £7,475. There's also a reduction in the threshold for higher-rate tax (£35,001 down from £37,401).
Older people see smaller increases in their personal allowances: if you're between 65 and 74, it goes up from £9,490 to £9,940, and if you're 75+, up from £9,640 to £10,090.
Rates are increasing in April. Employee and employer contributions increase by one percentage point, to 12% and 13.8% respectively. Additionally, the employee rate on earnings above the upper limit also increases from 1% to 2%.
Self-employed people will also see an increase, from 8% to 9%, and from 1% to 2% for the upper level.
The nil rate band is frozen at the amount introduced in 2009/10: £325,000.
Basic State Pension
The full basic state pension rises from £97.65 to £102.15 a week.
Tax credits will be reduced for families earning over £40,000; low-income families will receive more child tax credit.
A 0.76p per litre increase came into force in January 2011, with a further rise due in April.
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. From April 2016, to qualify for the full state pension, individuals will need 35 years’ of NI contributions.
Used by an employer or pension provider to calculate the amount of tax to deduct from pay or pension. A tax code is usually made up of several numbers followed by a letter. If you replace the letter in your tax code with ‘9’ you will get the total amount of income you can earn in a year before paying tax, for example 747L would mean a person could earn up to £7,479 before paying tax. The wrong tax code could mean a person ends up paying too much or too little tax.
Venture Capital Trusts were introduced in 1995 to encourage private investments in the small-company sector by offering tax relief in return for a minimum investment commitment of five years. A VCT is a company, run by a fund manager, which invests in other companies with assets of no more than £7m that are unlisted (not quoted on a recognised stock exchange) but may be listed on the Alternative Investment Market (AIM) or plus with the aim of growing the companies and selling them or launching them on the stock market. Investors in new VCTs are offered desirable tax advantages and VCTs themselves are listed on the London Stock Exchange, with strict limits laid down by HM Revenue and Customs on what they can invest in and how much they can invest.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Child tax credit
A scheme started in 2003 that sought to replace a raft of other tax credits and benefits, the payout depends on the number of dependant children in a family, and its level of income. The amount of credit is reduced as income increases. It is payable to the main carer of a child, usually the mother, and is available whether or not the recipient is working.
Enterprise Investment Scheme
A scheme set up to encourage investment into small, unquoted trading companies and give investors tax breaks to compensate for taking risk. Because the companies in the scheme are not listed on a stock exchange they often carry a high risk, so the tax relief is intended to offer some compensation. An EIS company cannot be a subsidiary, must trade wholly in the UK, can’t employ more than 50 people and certain activities (including forestry, farming and hotels) preclude companies from offering EIS relief.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.