How to ease your tax burden by using available allowances

As the enormity of the Chancellor’s tax measures sink in, it is abundantly clear that the UK faces several years under a historically high tax burden.

• The personal allowance and higher-rate income tax thresholds are frozen until 2028 along with the inheritance tax nil rate band
• The 45% top rate of income tax is set to kick in at £125,140 rather than the current level of £150,000
• There are big reductions to both the annual tax-free dividend allowance and capital gains tax exemption
• The deep freeze continues on the pension lifetime allowance as well as the annual pensions and ISA allowances

The extension of the freeze on the basic and higher-rate income tax thresholds until 2028 is going to steadily draw millions more into paying income tax for the first time and the higher rate of 40% for those earning over £50,271. The number drifting into higher-rate tax bands was already ballooning at a pace of 43.9% between 2019/20 and the current tax year to 5.5 million [1]. That number is sure to rocket much higher between now and 2028 given nominal wage rises.

The slashing of the threshold from £150,000 to £125,140 for paying the very top 45% tax rate, which will kick in next April, will pile on the tax burden for higher earners.

There is something that those subject to higher-rate taxes can do about it: pay into a pension because pension contributions attract tax relief at your marginal rate. This means for every £1,000 gross contribution made into a pension by someone paying 40% tax, the net cost will be just £600 with half of the tax relief going into the pension as a top up to boost its value and the other half reducing your income tax bill for the year of the contribution, via your tax return.

There had been speculation that the Chancellor might remove or reform higher-rate tax relief on pension contributions but like a cat with nine lives, higher-rate pension tax relief has once again lived to fight another day – for now. It continues to provide one of the best ways to reduce exposure to the higher rates of tax.

With high taxes here to stay for several years, it is vital to get as much of your savings and investments as possible into tax-efficient accounts. ISAs enable you to shelter savings and investments of up to £20,000 each tax year from HMRC, with all gains and income generated within them free from tax. This means couples can squirrel up to £40,000 a year into ISAs.

There are a number of different types of ISAs and some are very flexible, as withdrawals can be made at any time. It’s important to remember that with Stocks & Shares ISAs, while they can potentially give you better returns than Cash ISAs over the long term, as with any investments there is the risk of losing money.

With the annual allowance for tax-free dividends being halved from £2,000 to £1,000 next year, and then a mere £500 the year after, and the annual capital gains tax exemption being decimated from £12,300 currently to £6,000 next April and a meagre £3,000 from April 2024, those with shares or funds outside tax-efficient wrappers like ISAs and pensions, should consider migrating these into ISAs. This is a process known as a Bed & ISA and involves selling the shares or funds held and then repurchasing them with an ISA. When selling, care needs to be taken not to exceed the annual capital gains exemption. Until the end of this tax year, you can make a gain of up to £12,300 tax free, so there is a limited window of time to make use of this more generous allowance.

With personal tax allowances under pressure, one of the simplest things a married couple can do to organise their family finances tax efficiently is to make use of ‘interspousal transfers’ ie, switching savings and investments held to a spouse to make use of two sets of allowances or so that more assets are held by whichever spouse is subject to lower rates of tax. Married couples and civil partners are able to transfer assets between each other without triggering a tax event – this is not the case for unmarried couples.

Full use of family allowances can make use of two sets of capital gains exemptions, two dividend allowances and two ISA allowances and can therefore help reduce the overall amount of tax exposure for a family. However, before transferring shares, funds or cash to your spouse, it is important to understand that they will become the full, legal owner of the assets – so if your relationship is rocky, this should be borne in mind.

For those already making full use of pensions and ISAs, but with further cash available to tuck away, investing in new issues of Venture Capital Trusts provides a cocktail of tax benefits. Investment in new VCT issues provides a 30% income tax credit (the shares must then be held for at least five years) and any dividends or gains are also tax-free. For high earners with substantial mainstream investments portfolios, modest exposure to VCTs can help enhance a tax-efficient investment strategy. Up to £200,000 can be invested in VCTs each tax year, providing a potential income tax reduction of up to £60,000.

VCTs are afforded these tax incentives for a reason: to encourage investment in small, early stage, unquoted growth companies that meet strict criteria. They are inherently high risk – potentially more so during a recession – and so VCTs are not going to be suitable for everyone and exposure should only be modest. Although their underlying investments are businesses with growth potential, most VCTs aim to pay out returns made on these in the form of income. That’s because VCT dividends are tax free, so gains made on the successful sale of a business in the portfolio are usually paid out as special dividends rather than retained to drive capital growth. VCTs can therefore be used to supplement a tax-efficient income portfolio.

The annual inheritance tax nil rate band has been fossilised at £325,000 per person since 2009 and this will remain the case until 2028. With the real value of the allowance shrinking after inflation, no wonder then that increasing numbers of people are finding that their parents’ or grandparents' estates are falling into the web of inheritance tax when they die – this is sure to increase, especially as the freeze will cover a period when the generally affluent post-war baby boomer generation is approaching average life expectancy.

Inheritance tax is a tax that can be mitigated in numerous ways. These include gifting money away while you are alive – alongside various gifting allowances, any financial gift will be potentially exempt from inheritance tax if you live seven years after making it. Paying into a pension can also help reduce inheritance tax exposure and certain assets, including shares in Enterprise Investment Scheme (EIS) companies and many businesses listed on the AIM market, can qualify for Business Relief once held for two years, meaning that subject to certain conditions they will be exempt from an estate for inheritance tax purpose if held at death.

Investing in EIS or AIM companies for Business Relief is higher risk and these should be seen as longer term and less liquid investments, which should only be considered once other planning opportunities have been fully explored and form only a small part of your portfolio.

It is important to consider all the options for inheritance tax mitigation available, and so wise to take professional advice. Above all, before committing to a particular course of action, such as gifting money, make sure that this will not leave you with insufficient funds to finance your own retirement. A good financial planner will build a cashflow model of your assets, expected income and outgoings over time to help see whether you have the headroom to gift with confidence.

Alongside making use of ISAs and pensions to protect assets against capital gains tax, there are other steps that might be considered. For those with additional large sums of cash to invest outside of pensions and ISAs, using a multi-asset fund – rather than a portfolio of individual stocks or funds – can prove tax efficient. That’s because trades made within funds – such as in the normal course of investing – do not themselves clock up potential capital gains tax liabilities. These would only occur if shares in the fund itself were sold at a gain. Wealthier investors might consider establishing a private OEIC fund for the management of a family portfolio.

If you have realised a substantial, taxable gain – such as on the sale of a property or business – that faces a large capital gains tax bill, then one option to consider is to reinvest the gain made into a portfolio of Enterprise Investment Scheme (EIS) companies as this will enable the capital gains tax liability to be deferred. It doesn’t disappear but will recrystallise at a future date, ie when the EIS shares are sold. With careful planning, gains could be unwound over a number of tax years, to make use of future annual exemptions, or rolled over into new EIS. Providing they are held for two years, EIS companies do not form part of an estate for inheritance tax purposes and so, under current rules, a capital gains tax liability could be eliminated on death by using EIS.

Like VCTs, investment in EIS companies also provides a 30% income tax credit (subject to a minimum holding period). EIS companies are, however, higher risk, longer term and illiquid investments and will not be suitable for most people. Professional advice is essential.

Source

[1] National Statistics, Summary Statistics, GOV.UK