Maximise your tax efficiency

Beware of high marginal tax rates

There are four main tax rates -

  • a starting rate of 10% for the first £2,710 of savings income only, but if your non-savings income is above this limit, the 10% rate for savings income does not apply
  • 20% on the first £34,370 of taxed income
  • 40% on the next tranche of income up to £150,000
  • 50% above that level. However, there are also hidden marginal rates for two groups of people.

Age-related personal allowances

The personal allowance (currently £8,105) is withdrawn by £1 for every £2 of income above £100,000 so that it runs out completely when income reaches £116,210.

As a result, income between £100,000 and £116,210 has an eff ective marginal tax rate of 60%.

A similar situation arises with some pensioners. The elderly receive higher age-related personal allowances - £10,500 for those aged 65-74, and a higher amount of £10,660 for those aged 75 and above.

However, these higher allowances are abated where income exceeds the income limit, which this year is set at £25,400 until they drop to the level of the normal personal allowance of £8,105.

As a result, income between £25,400 and £30,190 for those aged between 65 and 74, and between £25,400 and £30,510 for those aged 75 and above, is effectively taxed at a rate of 30%. Income below that level is taxed at the basic rate of 20% and above that level up to the top of the basic-rate tax band is again taxed at 20%.

Take for example, Paul, who is aged 77. His income is £29,400, which is £4,000 above the income limit. As a result, his higher personal allowance of £10,660 is reduced by £1 for every £2 that his income exceeds the income limit.

As the excess income is £4,000, his higher allowance is reduced by £2,000 to £8,660 - see the table below.

How your marginal rate can grow

  £ £ £


INCOME LIMIT     25,400
DIFFERENCE     2,555
MULTIPLY BY 2     5,110
Level of income where abatement runs out     30,510
How this affects Paul      
INCOME     29,400
INCOME 29,400    
LESS: INCOME LIMIT (25,400)    
DIVIDE BY 2 4,000 (2,000)  
TAX THERON AT 20%     4,148

What can he do to avoid this effective tax rate of 30%? He could transfer income-producing assets to an ISA where the income would be tax-exempt (aside from 10% on dividend income).

Alternatively, he may be able to transfer income-producing assets to his spouse or civil partner so that the income is taxed in their hands.
A marginal rate of 60% for higher earners
The same problem applies to those earning between £100,000 and £116,210. On top of the ideas mentioned above, high earners in this band may also be able to make pension contributions or take a salary sacrifice.

For example, they could arrange with their employer to reduce salary or not take a pay rise and instead have the company make payments into their pension. Company pension contributions are not taxable on the individual. Such action also saves national insurance contributions for the employee and employer.

If they are self-employed or work for their own company, they may be able to employ their spouse and pay them a salary. The level of salary paid to a spouse would have to be justifiable in terms of the work that spouse performs for the business.

Again if they are self-employed, they may be able to run their business through a company and restrict the level of income, usually in the form of dividends, that they take out of the company so as to avoid the marginal tax rate of 60% on this band of income.

Pensions and ISAs

The amount of contributions you can pay into a pension is dependent on having sufficient earned income, so that if your income is, say £30,000, you cannot pay in more than £30,000 of gross contributions.

If you have no earnings, you can still pay in up to £3,600 gross a year. In the case of personal, stakeholder and self-invested personal pensions (SIPPs), contributions are paid net of basic rate tax, which equates to a net payment of £2,880. The government contributes the other £720.

These rules permit pension plans to be set up for non-working spouses, partners or children.

As explained above, contributions can also be paid into your personal pension by your employer.

For the individual, the tax advantages are significant – you get full tax relief on the contribution, so if your marginal rate is 60%, you get 60% tax relief on the contribution.

For a person on say £200,000 income, a £50,000 gross contribution will provide tax relief at 50% so that the actual tax saved is £25,000. Income within the fund rolls up taxfree, and you can take 25% of the fund on retirement tax-free. The rest of the fund will normally be used to purchase an annuity or you can draw down income and leave the fund invested within certain limits.

Capital gains tax

CGT is charged at 18% for most people but at 28% for higher-rate taxpayers. The first £10,600 of gains are tax-free as they fall within the annual exemption for CGT.

Approaching the end of the year, if you are sitting on potential losses, it may be worth selling the assets, triggering the loss to absorb gains already made above the annual exemption. It is not worth selling any further losses than are required to bring the total net gains below the annual exemption as these losses would effectively be wasted.

On the other hand, if you have realised losses to date but are sitting on gains, or if you have simply not made use of your annual exemption, you could sell shares, crystallise the gain to absorb the annual exemption, and perhaps some of the losses, and then buy back the shares.

The effect would be to re-set the shares at a higher CGT-base cost so that when they are eventually sold, the gain is that much lower and the CGT liability that much smaller.

'Bed and breakfasting' rules apply to try to prevent people from doing this, but it is still possible, provided you do not repurchase the shares within 30 days of the disposal. You can also avoid these rules by one spouse or civil partner selling and the other purchasing on the same day, thereby cutting the risk of the share price moving between disposal and re-purchase.

Alternatively you could bed and ISA – sell and re-purchase within an ISA. This would also remove all future growth and income from the tax net, so is especially taxefficient.

Inheritance tax

The IHT nil-rate band is £325,000. Gifts up to this amount are 'potentially exempt' in that you need to survive the seven years following the gift for them to become fully exempt. If you die within the seven years, the gains are added to your estate on death to work out the tax payable. Gifts to spouses and civil partners are fully exempt.

You can make a gift of up to £3,000 annually that is exempt from IHT along with any number of small gifts to different individuals of up to £250. If you didn't use the £3,000 annual exemption last year, you can make use of it this year to double-up to £6,000.

In addition, normal gifts out of income are fully exempt. The gift must be part of a series of annual gifts, each of which does not affect your standard of living and can be shown to be surplus to your living requirements. You should keep a record of such gifts and indeed all gifts made over the years, in order for your family to be able to justify tax-exemption following your death.

Top rate to drop to 45% next year

The top rate is to fall to 45% from this April. As a result, it might be possible to defer income from this year to next year so that it is taxed at a lower rate. For example, if you run your own company, you may be able to choose to take dividends after 5 April rather than before. It may be possible to defer bonuses until after the end of this tax year.

Conversely you may choose to make tax-efficient payments such as pension contributions before 5 April rather than after it, in order to get higher tax relief. For example, if you earn £200,000, you would get £25,000 in tax relief by paying £50,000 into your pension scheme, but after 5 April, you would get £22,500, so you can get an extra £2,500 in tax relief by acting before the end of the year.

This feature was written for our sister publication Money Observer

Your Comments

The notes on age allowance fail to mention that the its benefits are now quickly disappearing.The personal allowance is  being increased already and will reach £10K within 2 years whereas the age allowance of £10660 is,by all accounts, unlikely to be increased.Will the income limit of £25400 increase or even remain - this is anyone's guess.A declining benefit of ISAs for the elderly which I have yet to see expanded upon  in the media.
If you are on standard rate tax,take dividend income on ISAs and are unlikely to be liable for CGT now or in the future,some including me would say ISAs - what's the point?
What will happen if and when the universal pension starts in 2017 is far from clear.I have read one article which suggests that age allowance may continue but only for those reaching state retirement age on or after  6th April 2017.For older pensioners it won't.Another cause for consternation amongst pensioners perhaps.
I would appreciate clarification from Moneywise on what the likely future of age allowance and age related allowances generally are likely to be in the years ahead - or does anyone {including the government} really know at this stage?