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The personal allowance (currently £8,105) is withdrawn by £1 for every £2 of income above £100,000 so that it runs out completely when income reaches £116,210.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
|AGE-RELATED PERSONAL ALLOWANCE||
|NORMAL PERSONAL ALLOWANCE||8,105|
|MULTIPLY BY 2||5,110|
|Level of income where abatement runs out||30,510|
|How this affects Paul|
|LESS: AGE-RELATED PERSONAL ALLOW.||10,660|
|LESS: INCOME LIMIT||(25,400)|
|DIVIDE BY 2||4,000||(2,000)|
|ABATED PERSONAL ALLOWANCE||(8,660)|
|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.
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
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.
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.
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.
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.
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.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
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.