How to cut your income tax bill on earnings from £10,000 to £200,000
Most of us pay tax on everything from our income and company benefits to our weekly shopping and holidays. But, although our taxes are necessary to help fund schools, the NHS and the country’s infrastructure, no one wants to pay more than necessary.
Thankfully, a little bit of careful planning can help you hold on to as much of your hard-earned cash as possible. Strategies will vary depending on your income, and there are some key points along the salary scale at which it really pays to put your tax planning into action. Here are some examples of pretax salaries and the steps you might take to reduce the tax payable.
If you will earn £10,000 in the 2016/17 tax year, you shouldn’t need to pay a penny in tax on your income. Everyone receives a taxfree personal allowance of £11,000 on income from their job, any self-employment, pensions, some benefits and property.
As your total earnings are less than £17,000, you’ll also get tax-free interest on your savings. In addition, you get a £5,000 tax-free dividend allowance on any income you receive from share-based investments.
Being a non-taxpayer doesn’t mean you can just ignore tax planning, though. If you’re married or in a civil partnership, you and your partner should pay attention to which name any taxable income-producing assets are held under. “By shifting them into the name of the person in a lower tax band you could reduce the overall tax bill,” explains Jason Witcombe, director and certified financial planner at Evolve Financial Planners. “This might be worth considering if, for example, you have income from rental property.”
Although you can’t share salary between you, Mr Witcombe says you can transfer some of your personal allowance to a spouse or civil partner. The marriage allowance lets you transfer 10% of it – £1,100 this tax year – to your husband, wife or civil partner, providing they’re a basic-rate taxpayer (earning less than £43,000 in tax year 2016/17). You can apply for it online at gov.uk/apply-marriage-allowance and it will save your partner £220 in tax each year.
Furthermore, although you’re not paying tax, you can still benefit from tax relief at 20% on pension contributions. Gross contributions (the total amount once tax relief is added) worth up to your annual earnings or £3,600, whichever is higher, can be paid into your pension every year. On an income of £10,000, assuming you take advantage of the maximum pension contribution, you would only need to pay in £8,000 to get a £2,000 tax relief payment from the government.
If you’re earning £20,000 a year, welcome to the world of basic-rate income tax. You, along with nearly 30 million others, pay 20% income tax on your earnings in excess of the £11,000 personal allowance. On a salary of £20,000, that’s an annual tax bill of £1,800.
Although you’re paying tax, some of the strategies available to non-taxpayers are still worth considering, according to Danny Cox, chartered financial planner at Hargreaves Lansdown. He says: “Make pension contributions to get tax relief, and if you’re married, move taxable assets between you to reduce the overall tax bill.”
You will have a personal savings allowance that will entitle you to receive up to £1,000 of savings interest each year tax-free, and a £5,000 dividend allowance. In spite of these, Mr Cox recommends using your individual savings account (Isa) allowance of up to £15,240 for the 2016/17 tax year. “Although you probably wouldn’t pay any tax on savings and investments outside of the Isa wrapper, it’s still worth using Isas,” he says. “You shouldn’t be any worse off, and they could provide a useful shelter from income and capital gains tax in the future.”
With a salary of £40,000, you’re still a basic-rate taxpayer, but your annual income tax bill will now be £5,800.
Strategies such as moving assets between couples and using Isas still apply. In addition, although it might sound a bit perverse, Mr Witcombe says it can be worth putting the brakes on your pension contributions at this point. “Once you start earning more than £43,000, you’ll become a higher-rate taxpayer and get 40% tax relief on your pension contributions. If your salary is increasing and likely to push you into the next tax band soon, consider postponing pension contributions to get this additional tax relief.”
It is worth holding out for the difference. As a basic-rate taxpayer, paying £1,200 into your pension will get you £300 of tax relief, but as a higher-rate taxpayer you’ll double this to £600.
But this tip does come with a bit of a wealth warning. There is no guarantee that the current rules on pension tax relief will remain in place, and there has been plenty of speculation that higher-rate taxpayers will lose some of the extra benefit they get. However, as few expect the government to bring pension tax relief down below 20%, it may still be worth postponing if there is a possibility of getting the higher rate.
Congratulations! Once your earnings exceed £43,000, you’ve joined the 4.7 million Brits who pay higher-rate tax at 40%. Your personal savings allowance will fall from £1,000 to £500, but on the positive side, you will enjoy 40% tax relief on your pension contributions.
At £50,000, you are well into the higher-rate tax band: paying £2,800 a year in higher-rate tax in addition to the £6,400 you’ll pay in basicrate tax this tax year.
Importantly, at this point, your family’s entitlement to child benefit will start to reduce. Once your earnings exceed £50,000, you hit a tax charge – the high income child benefit charge. This comes into play if either your or your partner’s income exceeds £50,000, although you can both get away with earning £49,999 without the taxman getting sniffy.
With this, for every £100 you earn over £50,000, you’ll face a tax charge of 1% of the child benefit you receive. As an example, if you have three children you will be entitled to £48.10 of Child Benefit a week. But earn £55,000 and there will be a tax charge of 50% of this – equivalent to £24.05 a week or £1,250.60 a year.
If this happens, you could either pay the tax charge in your self-assessment, stop receiving child benefit altogether if your income exceeds £60,000 (the point at which you don’t receive any benefit at all) or find a way to reduce your income.
Ian Dyall, head of estate planning at financial planning firm Towry, explains: “You could make a pension contribution or charity donation to bring your income below £50,000 and avoid the tax altogether.”
In the example above, a £4,000 net contribution into your pension or to a charity would be grossed up to £5,000 with 20% tax relief. This would reduce your income to £50,000, getting you out of the tax charge, so effectively putting £1,250.60 back into your child benefit. What is more, because you are a higher-rate taxpayer, you would be able to claim back a further 20% through your tax return, giving you another £1,000 to spend on your kids.
Salary sacrifice, where you agree with your employer to reduce your income in exchange for the sacrificed income being diverted to a tax-efficient benefit, such as your pension, could also be worth exploring. Mr Dyall explains: “From a tax and income perspective, this has the same effect as making a pension contribution or donation to charity, but as you’re earning a lower salary, there are also national insurance savings for you and your employer.”
A salary of £100,000 means an income tax bill of £29,200, but go above this, and the amount of tax you’ll pay will rack up faster. This is because you will start to lose your income tax personal allowance. It is whittled away at the rate of £1 for every £2 of income you earn over £100,000.
“By the time you earn £122,000 in 2016/17, you’ll have lost the lot,” says Tony Mudd, divisional director of tax and technical support at financial advisory firm St James’s Place. “This represents an effective tax rate of 60% between £100,000 and £122,000. Consider making a pension contribution or donation to charity to avoid this.”
The additional rate of income tax – 45% – kicks in once you start earning more than £150,000. Such an income puts you in a tax band with just 333,000 other people. While it might be a relatively exclusive club, and you’ll get 45% tax relief on pension contributions, being in this group is not without its drawbacks.
You will lose the £500 personal savings allowance, and the £40,000 pension annual allowance will start to be tapered down to £10,000 at the rate of £1 for every £2 of income in excess of £150,000. This means that once your income hits £210,000, you will only have an annual allowance of £10,000.
It is important to note how this taper works, as it may kick in well before your salary reaches £150,000. The HMRC rules define pension contributions – both your own and any from your employer as well as other income sources such as dividends and rent from a buy-to-let property – as income for this £150,000 threshold. It won’t automatically kick in, though, as it also requires your income, after pension contributions are taken off, to be more than £110,000.
Unfortunately, there are no easy fixes if you get caught by this. Instead, Mr Cox suggests taking full advantage of the pension ‘carry forward’ rules. “Once you’ve used this year’s pension allowance, you can mop up any unused allowance from the previous three years,” he explains.
In 2016/17, this means you could access a further £130,000 of pension allowance (£50,000 in 2013/14 and £40,000 in each of 2014/15 and 2015/16), minus any contributions you had already made for those years.
By the time your income hits £200,000, your tax allowances will seem vanishingly small. For some, your income tax allowance and your personal savings allowance will have disappeared altogether, while for others, your pension annual allowance will have shrunk considerably. This can also have a shrinking effect on your take-home pay. By the time you have paid £76,100 in income tax and national insurance of £7,332.80, your £200,000 salary will become a take-home pay of just over £116,500.
Mr Mudd says that at this point, it may be worth looking at some of the more sophisticated tax-efficient investments, such as venture capital trusts (VCTs) and enterprise investment schemes (EISs). “Both of these provide income tax relief at 30% on investments in newly issued shares,” he explains. “This means that if you invest £50,000, you would get a tax credit of £15,000 to offset against income tax you had paid that year.”
There is also a third form of tax-efficient investment – a seed enterprise investment scheme (SEIS) – which offers 50% income tax relief on investments. With all three, there are limits on how much you can invest to get income tax relief: £200,000 a year for VCTs, £1 million for EISs and £100,000 for SEISs – and you’ll need to have paid the tax to be able to use the tax relief.
But while investing in these could give you enough tax relief to wipe out your income tax bill, Mr Mudd says it is essential to understand the risks. “There is no such thing as a free lunch: these are all high-risk investments in small companies, so you could potentially wipe out your investment alongside your income tax.”
If taking this level of risk isn’t something you feel comfortable with, you might want to consider a more radical approach to tax planning. Mr Witcombe explains: “Why not drop down to a four-day week? It is not always possible, or something you’d necessarily want to do, but as well as saving you tax, it could improve your worklife balance.”
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.
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.
A tax-efficient way of receiving staff benefits, where an employee agrees to forego a proportion of their salary for an equivalent contribution into their pension scheme or in exchange for company car, gym membership, childcare vouchers or private medical insurance. A salary sacrifice scheme is a matter of employment law, not tax law, and is often entered by an employee who is about to move into the higher 40% tax bracket.
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.
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.
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.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
The catch-all term applied to investors who buy properties with the sole intention of letting them to tenants rather than living in them themselves, with the proceeds from the let usually used for the repayment of the mortgage. Buy-to-let investors have to take out specialised mortgages that carry higher interest rates and require a much bigger deposit than a standard mortgage. Other expenditure can include legal fees, income tax (on the rental profits you make), capital gains tax (if you sell the property) and “void” periods when the property is unlet.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.