Halloween's almost here, and ahead of the 31 October, Hannah Smith shares the best ways to keep your HMRC bills to a minimum.
There’s a raft of different tax breaks on offer in the UK, but a few are often overlooked by savers and investors. Using them correctly means you can reduce your tax bill and keep as much of your investment returns as possible. Here is a guide to some of the possible tips and tricks you could use (but speak to a financial adviser for proper tax planning advice).
Why is planning important?
Tax planning isn’t tax dodging. It’s a legitimate way to make the most of the tax breaks to which everyone is entitled.“There are plenty of legitimate tax planning opportunities available: it is about maximising the benefits you can get from the rates, bands and allowances built into the tax system. It can be complicated, but that gives rise to opportunities,” says Graeme Robb, technical manager at Prudential.
Before you try any clever tricks, the first rule is quite simply to make as much use as possible of tax wrappers (saving and investment vehicles which shield your money from the taxman) including Isas, pensions and investment bonds, to avoid paying unnecessary tax. If you are lucky enough to have the financial muscle to maximise all your available allowances, you could end up legitimately not paying tax on as much as £50,000 of savings, Robb estimates.
Make the most of your pension
The government wants you to save into a pension, so it incentivises you with several valuable tax breaks. One is pension tax relief, which adds the money you would have paid in income tax on your earnings directly into your pension pot. You get tax relief at 20% for basic-rate taxpayers, 40% for higher-rate taxpayers, and 45% for additional taxpayers.
Importantly, while basic-rate tax relief is added automatically by your pension provider, you have to claim back higher and additional rate relief each year, either by filling out a self-assessment tax return or by contacting HMRC. If you haven’t been doing this, you could be missing out on a significant amount of money. You can claim tax relief on pension contributions for past years, as long as they are within four years of the end of the tax year for which you are claiming.
The annual allowance is the maximum you can contribute to a pension tax-free. In the current tax year it is £40,000 (unless you are already drawing down your pension), and it is tapered for high earners (£150,000 plus). You may be able to carry forward unused annual allowance from the previous three years, which is useful for those who might otherwise exceed the pension contribution threshold in one year. But the rules are fiendishly complex, so consult a professional adviser.
If you are a small-business owner, making pension contributions through your limited company could be a tax-efficient move. That’s because it is treated as a business expense and offset against your corporation tax bill.
And if you’re already at retirement or near retirement age, you can take up to 25% of your pension pot tax-free, either in smaller withdrawals to get an income, or as a lump sum. This is called the pension commencement lump sum. You’ll then have six months to buy an annuity or go into drawdown with the rest, providing taxable income.
Rule of thumb: be sure to claim all your pension tax relief, including for past years.
Five less familiar tax allowances
|Allowance||Max ann value (£)||What does it do?|
|Marriage allowance||1,250||Transfer up to 10% of personal allowance to spouse|
|Dividend allowance||2,000||Tax-free dividend income|
|Trading allowance||1,000||Tax-free trading eg selling on eBay|
|Property allowance||1,000||Tax-free gains from property earnings eg AirBnb|
|Tax deferred allowance||5% of investment bond||Tax deferred on withdrawals|
Maximise use of your personal allowances
Everyone gets certain personal tax allowances from the government, such as the Isa allowance, worth £20,000 in the 2019/20 tax year, and the Junior Isa allowance, which lets you make savings contributions of £4,368 a year for a child under the age of 18.
A key one is the personal allowance, which lets you earn £12,500 without paying any income tax.
It’s tapered for high earners, meaning it goes down by £1 for every £2 of adjusted income (all income plus pension contributions) you earn above £100,000. If your taxable income goes above £125,000, you lose your personal allowance.
You can lower the tax you pay by reducing your taxable income, suggests Rachael Griffin, head of trusts and technical solutions at Old Mutual Wealth. Workplaces may offer salary sacrifice schemes where you can pay for benefits like health insurance, childcare, a bike or a company car out of your gross salary, for example, reducing your take-home pay.
“There are ways, if you’re still earning, to be able to reduce your income through making pension contributions or charitable donations, so as not to lose all your personal allowance,” she says. You could also defer your state pension, if you are at an age where you are entitled to claim it but you have enough taxable income to live on from other sources.
If you are a couple, make sure you are both using your personal allowances to the full. One way to do this is for one half of the couple to employ the other in their limited company, for example. But they do need to actually work for the business, and you must pay them a realistic wage.
Another way, if you are married or in a civil partnership and one partner is a non-taxpayer, is to make use of the marriage allowance. An often-overlooked tax break, this could be worth £1,250. “A lot of clients use the marriage allowance to give up to 10% of their £12,500 personal allowance to the one who needs it more,” says Lee Glennan, founder of Glennan Wealth Management. “If one partner works and one doesn’t, you can transfer the non-working partner’s allowance to the higher-rate taxpayer. It’s money for nothing, you can get a cheque in days and you can backdate your claim by four years.”
With the dividend allowance, you don’t pay tax on the first £2,000 you earn in dividends from investments (for example, from your dividend-paying shares or equity income funds). “You could have an Oeic [open-ended investment company] portfolio with some funds paying interest and some paying dividends, depending on the type of fund you are in,” Robb explains. “You could construct a portfolio so your interest is getting mopped up by your savings allowance and your dividends are getting mopped up by your dividend allowance.”
Glennan says that his retired clients often hold their share portfolios in one name just because that’s the way they’ve always been, when in fact they should be putting at least part into the name of the spouse who still has some dividend allowance available – and this would also be free of capital gains tax.
One often-overlooked allowance for people holding investment bonds (a life insurance policy where you can invest a lump sum in a range of funds) is the tax deferred allowance which lets you withdraw up to 5% from a bond each year without incurring an immediate tax charge. “This is very efficient for a higher- or additional-rate taxpayer who might become a non-taxpayer or a basic-rate taxpayer in future, as they can defer crystallising their gains until they are in that lower tax bracket. Or you could assign it across to another family member as a gift as part of an inheritance tax strategy,” says Robb.
A couple of smaller allowances you may not have heard of are the trading allowance (which gives you £1,000 taxfree from freelancing or selling on eBay, for example) and the property allowance (£1,000 tax-free if you make money on your property through AirBnb, for example, or by renting out your driveway). Note, though, that the rent-a-room scheme is more tax-efficient for most people letting out rooms, and you can’t use both tax reliefs at once.
Rule of thumb: couples should ensure both partners use their personal allowance.
Be clever with capital gains
When you sell an asset such as your share portfolio or a second home and make a profit on it, you’ll usually be liable for capital gains tax (CGT). You can earn £12,000 of profit tax-free before you have to pay CGT – this is your CGT allowance. Above that, you’ll pay 10% on assets and 18% on property as a basic-rate taxpayer, and 20%/28% if you pay higher-rate tax. There are a few ways to mitigate your CGT bill.
Clever timing could help with CGT planning. You can make partial withdrawals, such as cashing out a lump sum in two different tax years to maximise your annual exemptions. “With CGT, you have an annual allowance and if you don’t use it, you lose it,” explains Griffin. “If you own a portfolio of shares that you allow to grow for five years and then cash it out all at once, you would trigger a CGT bill on all the gains above your CGT allowance for that year. But if you staggered your withdrawals over a few years, you could make the most of your allowance and make large savings.” However, she cautions that you shouldn’t sell your shares for tax reasons alone, in case it’s not the right time to sell.
You can also offset any gains you have made on your assets against your losses for a lower CGT bill. For example, you could realise losses from poor-performing funds in the same tax year as you realise the gains from your strong performers. You can count losses from past years, depending on the asset type.
“How about using your Isa allowance as soon as the tax year begins, and funding this from a taxable general investment account by making sales in the previous tax year, with Isa buys in the new tax year?” suggests Dan Woodruff, founder of Woodruff Financial Planning. “This uses the tax-saving power of Isas, and can also retain the investor’s capital gains tax allowance, potentially saving even more tax in future.”
Spousal exemption rules mean you can transfer assets to your spouse for them to sell if they have an unused CGT allowance.
Investors’ relief gives you a CGT rate of 10% on disposals of shares in an unlisted trading company, as long as you have held the shares for at least three years. Entrepreneurs’ relief is similar, at 10%, and both are up to a lifetime relief limit of £10 million. Investors’ relief works in a similar way to entrepreneurs’ relief but it is not a replacement for it, so it is possible to be eligible for both, says Glennan.
Rule of thumb: timing is an important consideration with CGT planning, as is offsetting losses against gains.
Other tax-efficient wrappers: VCTs and EIS
Venture capital trusts (VCTs) are designed to make it more attractive for investors to back young companies by offering no tax on dividends if they are held for five years, up to 30% income tax relief for subscriptions in new VCT fund raisings, and no capital gains tax (CGT) when they are sold. They can be useful to those who have hit the pension lifetime allowance, so they have been popular with wealthy investors willing to take some investment risk. Some £731 million was invested in VCTs during the 2018/19 tax year, making it the second-best year ever for these vehicles.
Enterprise Investment Schemes (EIS) offer 30% income tax relief and CGT exemption on disposal if you hold them for three years, and qualify for business property relief (BPR) if you hold them for at least two years, which means they do not form part of your estate for inheritance tax purposes. Unlike VCTs, their dividends are taxable; but you can claim relief on income tax you paid in the previous tax year.
The government is concerned that EIS is being used primarily for tax planning rather than for the intended purpose of supporting entrepreneurs, and there is speculation it might strip Aim shares of inheritance tax relief, which could make the sector less attractive to many investors.
“We use them with clients but we tread carefully,” says Glennan. “We deal with clients who are at or in retirement and want to hold on to what they have; although the 30% tax relief is attractive, you don’t want the tax tail to wag the investment dog.”