We are about three-quarters of the way through the current tax year, so now is a good time to take a good look at your financial affairs to see what can be done to minimise your tax bill and put a strategy in place to reduce future tax bills.
Watch out for high marginal tax rates
There are four main tax rates:
• A starting rate of 10 per cent for the first £2,560 of savings income – if your
non-savings income is above this limit, the 10 per cent rate for savings income does not apply
• A 20 per cent rate on the first £35,000 of taxed income
• A 40 per cent rate on the next tranche of income up to £150,000
• A 50 per cent rate on income above £150,000
However, there are hidden marginal rates for two groups of people.
The personal allowance (currently £7,475) is withdrawn by £1 for every £2 of income earned above £100,000 and runs out completely when income reaches £114,950. As a result, income between £100,000 and £114,950 has an effective marginal tax rate of 60 per cent.
A similar effect occurs with some pensioners. The over-65s receive higher age-related personal allowances of £9,940 for those aged 65 to 74 and £10,090 for those aged 75 and above. However, these higher allowances are abated where income exceeds the income limit, which this year is set at £24,000, until they drop to the level of the normal personal allowance of £7,475.
As a result, income of between £24,000 and £28,920 for those aged between 65 and 74, and between £24,000 and £29,230 for those aged 75 and above is effectively taxed at a rate of 30 per cent. Income below that level is taxed at the basic rate of 20 per cent. Above that level, up to the top of the basic-rate tax band, income is also taxed at 20 per cent.
To see how a pensioner might be affected, let’s consider the case of Jenny, who is 78. Her income is £27,000, which is £3,000 above the income limit. As a result, her higher personal allowance of £10,090 is reduced by £1 for every £2 that her income exceeds the income limit. As the excess income is £3,000, her higher allowance is reduced by £1,500 to £8,590.
What can she do to avoid this effective tax rate of 30 per cent? She could transfer income-producing assets into an Isa, where the income would be tax exempt. Alternatively, she might be able to transfer income-producing assets to her spouse or civil partner so that the income is taxed at the rate they pay, which could be lower.
A similar line of thinking may help people whose income is between £100,000 and £114,950. Depending on their individual circumstances, they may also be able to start or increase pension contributions. Alternatively, 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 the spouse performs for the business.
Salary sacrifice, where they agree with their employer to reduce their salary and increase their pension payments, may be another option. Employees are not taxed on company pension contributions.
If they are self-employed, they may be able to run their business through a company. They can then restrict their level of income – usually by paying themselves dividends instead – and avoid a marginal tax rate of 60 per cent.
You can invest up to £10,680 in an Isa in this tax year (and up to £11,280 next year) comprising up to £5,340 (£5,640 next year) in a cash Isa and the rest in a stocks and shares Isa. Cash Isa income and stocks and shares Isa gains are not taxed. Recently, many people have suffered Isa losses and found that they can’t offset these against gains made elsewhere.
From November, Junior Isas became available for children aged under 18 who don’t have a child trust fund. The annual investment limit is £3,600 for this tax year and the next. From April 2013, the limit will be indexed, as is the case with normal Isas.
Unlike standard Isa savings, Junior Isa savings cannot be touched until the child reaches the age of 18, so they can be a tax-efficient way to help children build up a university fees fund.
The pension contribution limit changed this year. You can now put a maximum of £50,000 a year into your pension. This annual limit represents an enormous reduction in the £255,000 limit of the previous year. The lower limit was introduced by the previous government to cut the level of tax-free contributions being made by the wealthy.
The amount of contributions you are allowed to make up to the new limit depends on your earned income. If your income is £30,000, for example, 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. With personal, stakeholder and self-invested pension plans, as contributions are paid net of basic-rate tax, this 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.
Contributions can be paid by your employer into your personal pension up to the contribution limit.
The tax advantages of this are significant. You get full tax relief on the contribution, so whatever your marginal tax rate is, you get that relief on the contribution. If, for example, your marginal rate is 60 per cent, you get 60 per cent tax relief on the contribution.
Income in the fund rolls up tax free, and you can take 25 per cent 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.
Investing in qualifying enterprise investment scheme companies has tax advantages, although it’s advisable to only invest in such companies if you have researched their viability. This should be seen as a relatively risky form of investment.
You can invest between £500 and £500,000 in new shares in a company and get immediate 20 per cent income tax relief in the year of investment, or you can choose to carry the relief back to the previous year.
Either way, you must have sufficient income in that year to cover the cost of the investment and the shares must be held for at least three years. Gains are tax free provided the income tax relief has not been withdrawn – because, for example, the company has changed its activities and ceased to qualify for the EIS.
If the shares are sold at a loss, you can set the loss (less any income tax relief previously received) against income rather than gains in the year of disposal or the previous year.
Capital gains on the disposal of any asset can be deferred by investing the gains in EIS company shares up to one year before or three years after the gain arose. The deferred gain is brought back into the tax net when the EIS shares are sold.
These tax breaks are available to investors who are not connected with the company. People who are connected (employees or existing shareholders, for example) will not be entitled to the income tax relief or capital gains tax exemption but can still benefit from loss relief and CGT deferral.
Capital gains tax pointers
Capital gains tax is now charged at 18 per cent, or 28 per cent for higher-rate taxpayers. The first £10,600 of gains are tax free, as they fall within the CGT annual exemption.
Approaching the end of the year, if you are sitting on potential losses on assets, it may be worth selling them to trigger a loss and absorb gains already made above the annual exemption. It is not worth selling more assets than are required to bring total net gains below the annual exemption, as these losses would be wasted.
The same principle applies the other way around. 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 the 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 reset the shares at a higher CGT-base cost, so that when they are eventually sold, the gain is much lower and the CGT liability smaller.
‘Bed and breakfasting’ rules 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 minimising the risk of the share price moving between disposal and repurchase.
Alternatively, you could bed and Isa – sell and repurchase in an Isa. This would also remove all future growth and income from the tax net, so it is especially tax efficient.