When it comes to budgets, tax rates and tax bands, be careful, the devil is always in the detail!
Jeremy Hunt, the Chancellor of the Exchequer, recently stepped up to give his fiscal update and announce changes to the tax system. On the surface, there were some pleasant surprises. However, the attention-grabbing headlines quickly gave way to a more detailed analysis.
Income tax
Time and time again, governments have promised not to increase tax rates while somehow they have managed to increase income tax receipts. This brings us to the concept of “fiscal drag”, a subtle yet very effective strategy used by all governments.
What is fiscal drag?
To put this into perspective, fiscal drag is more commonly associated with income tax, particularly tax bands. Suppose we assume that wages increase in line with inflation. In that case, if tax bands also grow in line with inflation, then in relative terms, your income tax liability should remain relatively constant. However, what happens if the government decides not to increase tax bands in line with inflation?
Here is an example of fiscal drag in action:
Earnings 2022/23 tax year: £12,570
Personal tax-free allowance: £12,570
Taxable earnings: £0
Tax payable: £0
Earnings 2023/24 tax year: £13,827 (a 10% increase)
Personal tax-free allowance: £12,570
Taxable earnings: £1257 (at 20%)
Tax payable: £251
While these figures demonstrate the impact of fiscal drag on a relatively low income, it is easy to see how this strategy could push a higher earner into the next tax band. If the Chancellor continued this strategy into the next financial year, this would significantly increase government tax revenues.
Dividend allowance
It is common for those who own their own business to take a relatively low salary and significant dividends out of profits. Before changes for the 2023/24 tax year, individuals had a dividend allowance of £2000 a year. This meant that the first £2000 of dividend income was tax-free.
Changes announced in the budget mean that the dividend allowance will be reduced as follows:
Tax year 2023/24: £1000
Tax year 2024/25: £500
Consequently, any dividend income above the allowance will be subject to taxation. The current rate is 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for those on the additional rate.
Capital gains
We will now look at how recent changes will impact capital gains taxation as we advance. This subject is important in relation to tax-free wrappers such as ISAs and pension schemes.
Capital gains tax allowance
In a marked change to historical capital gains tax policy, the UK government announced a reduction in the allowance over the next two tax years. This means more capital gains are likely to be added to income and taxed at the appropriate rate
Here is a summary of changes to the capital gains tax allowance:
Tax year 2022/23: £12,300
Tax year 2023/24: £6000
Tax year 2024/25: £3000
This equates to a 75% reduction in an individual’s capital gains tax allowance over two tax years, unprecedented under a Conservative government.
ISA allowance
Individual Savings Accounts (ISAs) replaced Personal Equity Plans (PEPs) in 1999, offering a tax-efficient way to save and invest. Even though the ISA annual allowance has been frozen at £20,000 since the 2017/18 tax year, as has the Junior ISA, which stands at £9000 per annum, they shouldn’t be overlooked. As funds/investments are shielded from income and capital gains, this enhances potential returns, with some ISAs now worth more than £100,000 while others have breached the £1 million level.
Those with significant investment portfolios may benefit little from a one-off £20,000 annual allowance. However, the cumulative impact of maximising your annual ISA allowance year on year can be substantial. Even where there are no additional funds available, there is potential to utilise your capital gains tax allowance and consider switching investments/funds into an ISA.
Pension allowance
Surprisingly, the UK government increased the annual pension allowance from £40,000 to £60,000 starting in April 2023. Where eligible, individuals can now enhance their pension contributions, and associated tax relief, up to a maximum of £60,000 a year. Akin to ISAs, capital gains and income accumulated within a pension fund are typically tax-free. Consequently, it is not difficult to see the potential to significantly enhance pension fund returns long-term by maximising contributions and using the exemption from capital gains and income tax.
The cumulative impact
While some of the above allowances and exemptions are significant in their own right, the cumulative impact can make a real difference. For example, switching investments into tax-free wrappers, ISAs, and pension funds could significantly enhance your long-term returns.
However, as we see with both the dividend and capital gains tax allowance, it may be a little naïve to assume that any allowances will be retained or enhanced going forward. Consequently, you must seek advice from your financial adviser to maximise your income and minimise your tax liabilities.
Get in touch
For more information on maximising your income, get in touch with one of our financial planning experts, or email us at admin@cedarhousefinancial.co.uk.