When looking to maximise your income and investment returns, it is essential to fully use tax allowances and tax breaks. While the government will often tweak and change various elements of the tax system, we have rarely faced the level of change seen since September 2022.
In less than 18 months, we have had a Mini-Budget and the traditional Autumn and Spring Budgets. When looking at allowances and tax breaks, it is essential to look at them on a long-term basis. Some may seem irrelevant in the short term, but the annual cumulative compound impact on your long-term income/wealth can be significant.
Maximising Income Tax Breaks
In general, it is often the case that no news is good news when it comes to taxation. But unfortunately, this is not the case concerning income tax. Traditionally, the various tax bands are increased in line with inflation, which should broadly reflect wage rises. This means that in relative terms, most taxpayers should see little or no change in the amount of income tax paid.
When Jeremy Hunt, the Chancellor of the Exchequer, stepped forward with his Autumn Budget and announced no change in tax bands, many were relieved. However, this lack of action will ultimately see millions of people in the UK pay more taxes.
Fiscal drag
In a process known as “fiscal drag“, while the government can still claim not to increase income tax rates, millions of people face an increase in their income tax. This is because any wage increase is not counterbalanced by raised tax bands. Therefore many will pay more tax or, in a worst-case scenario, move into a higher tax band.
An example of fiscal drag in action:-
Earnings 2021/22 tax year: £12,570
Personal tax-free allowance: £12,570
Taxable earnings: £0
Tax payable: £0
Earnings 2022/23 tax year: £13,827 (a 10% increase)
Personal tax-free allowance: £12,570
Taxable earnings: £1257 (at 20%)
Tax payable: £251
In this example, the individual has gone from paying no tax in the 2021/22 tax year to paying £251 in the 2022/23 tax year. As the 10% increase on the previous year’s income would have helped maintain spending parity in line with inflation, the £251 tax payment reduces their relative income.
Marriage allowance
In certain circumstances, the marriage allowance (also applicable to civil partners) is used to offset the income tax liability of the higher earner. Where one individual is not maximising their allowance of £12,570, they can transfer a maximum of 10% to their spouse/partner. In this situation, the maximum tax saving is £252 per annum (20% of the transferred allowance).
An example of the marriage allowance in use:-
Partner 1
Earnings 2022/23 tax year: £8,000
Personal tax-free allowance: £12,570
Taxable earnings: £0
Tax payable: £0
Partner 2
Earnings 2022/23 tax year: £15,000
Personal tax-free allowance: £12,570
Taxable earnings: £2430 (at 20%)
Tax payable: £486
Using the marriage allowance:-
As partner one has not fully utilised their personal tax-free allowance, they can transfer up to 10% to their spouse/partner. This changes the tax calculation for partner two as follows:-
Partner 2
Earnings 2022/23 tax year: £15,000
Personal tax-free allowance: £12,570 + £1257 (from partner) = £13,827
Taxable earnings: £1173 (at 20%)
Tax payable: £234 (a saving of £252)
Salary sacrifice
Especially in the current situation, where fiscal drag comes into play, even a relatively modest pay rise could increase your income tax liability. In some cases, this may push you into the next tax band and raise your top rate of income tax. However, there is a process known as salary sacrifice, which you can use to reduce your tax burden.
Let us assume that you earn £50,270 a year (the maximum level of income in the basic rate tax band) and have been offered a £5000 pay rise – which would take you into the 40% higher tax band. This equates to an additional £2000 a year in income tax. In this situation, you can make an arrangement with your employer to effectively “sacrifice” the salary rise so you don’t move into the higher tax band. However, rather than losing your salary increase, you would arrange for your employer to enhance their contribution to your pension fund by £5000 a year.
As the additional pension fund contribution does not count towards your salary, you effectively remain at £50,270 a year while benefiting by a further £5000 gross payment into your pension fund.
Dividend allowance
While not often discussed, the dividend allowance is the amount of dividend income an individual can receive each year free of additional tax. In the 2022/23 tax year, this allowance stood at £2000, although it will be reduced over the next two years:-
Tax year 2023/24: £1000
Tax year 2024/25: £500
Any dividend income received above the allowance will be subject to additional taxation. This extra tax rate is currently set at 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for additional rate taxpayers.
Maximising Investment Tax Breaks
We have seen several changes in recent times regarding investment tax breaks. On the one hand, we have a reduction in the capital gains tax allowance, while on the other hand, there have been some beneficial changes regarding pensions. Consequently, it is essential to take professional financial advice about your income and investments with the tax landscape constantly changing.
Capital gains tax allowance
Similarly to income tax bands, the capital gains tax allowance has historically increased to take account of inflation and rising asset values. However, this historic policy was recently subject to a significant U-turn. As a result, further highlighting the benefits of investment tax breaks such as pension contributions and ISAs, the individual capital gains tax allowance will be reduced over the next couple of years.
Tax year 2022/23: £12,300
Tax year 2023/24: £6000
Tax year 2024/25: £3000
Due to the reduction in the capital against allowance, capital gains crystallised above this level will be added to your income and taxed at the appropriate rate.
ISA allowance
Individual Savings Accounts (ISAs) were introduced in 1999, replacing the earlier Personal Equity Plans (PEPs). These are tax-efficient investment vehicles which are shielded from income and capital gains. However, the annual ISA allowance has been frozen at £20,000 since the 2017/18 tax year, and the limit for Junior ISAs currently stands at £9000 per annum. While in isolation, these amounts may seem minimal for relatively large portfolios, the cumulative impact on compound returns can significantly improve the value of your investments.
While there were rumours that the government was considering introducing a £100,000 cap on ISAs, nothing has materialised. If this situation were to change, there would be tax implications for those with ISA accounts valued at over £100,000. Many people had also expected a reduction in the annual ISA allowance. Consequently, where applicable, it is essential to use your annual ISA allowance to shield investments from income and capital gains tax.
Pension contributions
Surprisingly, the Spring Budget saw Jeremy Hunt increase the annual pension allowance from £40,000 to £60,000 from April 2023. Consequently, tax relief is now available on an additional £20,000 of pension contributions per year. The annual money purchase allowance also increased from £4000 up to £10,000, the maximum contribution you can make to a pension already in drawdown.
Pension lifetime allowance
The pension lifetime allowance currently stands at £1,073,100 and is the maximum value for a pension fund without facing additional tax charges on withdrawals. However, this was suspended from April 2023 and will be abolished from April 2024. While this will remove additional tax charges, the government has also frozen the tax-free lump sum limit at 25% of the current lifetime allowance. This equates to £268,275 unless you have protection that entitles you to a higher level.
National insurance contributions
Under standard rules, you can fill gaps in your national insurance contributions going back over the last six years. However, upon the launch of the new state pension, those eligible for a state pension after April 2016 were allowed to go back an additional ten years, to 2006, to fill gaps in their national insurance payments. While the six-year rule will remain in place, the opportunity to backdate payments to 2006 ended on 31 July 2023.
Depending on your situation, there may be significant benefits in addressing any gaps in your national insurance contributions. Consequently, it is vital to take professional advice as soon as possible.
Adapting to a changing environment
In recent years we have seen significant movement concerning pension regulations, pension contributions, and the lifetime allowance. It is also possible to carry forward any unused pension contributions allowance from the last three years. There’s also the option of addressing gaps in your national insurance contributions. On the downside, fiscal drag and reductions in capital gains tax and dividend allowances could lead to greater tax liabilities.
It is essential to fully utilise income/investment allowances and tax breaks, which can prove hugely beneficial in the short, medium and long term. For example, maximising your pension fund contributions over 40 years will lead to significant funding and potentially enhanced compounded investment returns.
Summary
Creating a long-term financial plan while adapting short-term targets to address changes in taxation is something you should discuss with your financial planner. Contact us today, and let’s arrange a time to review your finances and options in more detail.