What should I do with surplus income?

For many, the coronavirus pandemic has brought about a reduced salary, furlough or unemployment, leading to a significant decrease in household income. But there are others – those on a fixed or stable income from pensions and investments or with secure employment – who have saved more as opportunities to spend have diminished during lockdown.

This can lead to an increase in surplus income, which, if just left to accumulate, can increase the size of an estate and potentially result in Inheritance Tax at 40%. Here are some simple but effective ways to use surplus income.

Savings and pensions

One of the most tax-efficient ways of using surplus income is to make pension contributions, as they normally receive tax relief at one's highest marginal rate. Most pensions generally do not form part of an estate so as well as reducing an Income Tax bill and providing for retirement, making pension contributions can also help reduce any liability to Inheritance Tax.

Of course, it has been very well reported that pension tax relief for higher and additional rate taxpayers could be under threat with the Treasury needing to replenish coffers following the outlay caused by Covid-19. Because of this, it’s probably wise to take full advantage of the generous pension tax breaks sooner rather than later.

One of the downsides of pensions is that they can only be accessed in retirement. The current crisis has highlighted how important it is to have readily accessible funds available for weathering extended periods with reduced or no income. For those who do not have enough readily available funds to support themselves for 12 months, maximising contributions to ISAs for themselves and their spouses could be a better option than pensions. The accessibility of the ISA without tax may give peace of mind. Flexible ISA rules also mean it is possible to withdraw funds and reinvest them in the same tax year.

Life cover and protection

Living through a health crisis has forced people to consider their own mortality and the potential financial implications resulting from death or illness. Many people in the past chose not to think about the implications of long-term illness or the impact that their death would have on their family and, as a result, lack adequate protection. Others may have been made redundant or changed jobs and the protection that was in place from their previous employer may no longer be available.

For those who are financially secure, or who have adequate cover in place, a life policy written in trust is an effective way of establishing a fund outside an estate which can be easily accessed prior to probate to pay any Inheritance Tax liability. If premiums are paid from excess income, the normal expenditure exemption can be used to cover the premiums.

Making gifts

Many people choose to start putting money into a trust to help younger members of their family who may not be as financially stable as themselves. Again, regular gifts from surplus income into trust may qualify for the normal expenditure from income exemption for Inheritance Tax purposes. To qualify for this exemption, gifts must be regular, payable from income and not deplete the donor’s standard of living. Amounts regularly given can fluctuate in value in line with the amount of surplus income. However, if the surplus income is only going to be temporary, this exemption is unlikely to be relevant.

If regular premiums do not qualify for this exemption or a lump sum is gifted to the trust, then this will be a chargeable lifetime transfer. However, no tax will be payable unless the cumulative total of the chargeable lifetime transfer over the last seven years exceeds the nil rate band.

Giving to charity

According to the Institute of Fundraising, as a result of the Covid-19 pandemic, UK charities are projecting a 50% reduction in voluntary income and more than a third of their total income. Surplus income could be used to make gifts to charity to help alleviate this problem. These are free from Inheritance Tax and donations are also eligible for Gift Aid.

Speak to Tilney

Tilney’s financial planners can help you make informed decisions about what to do with surplus income. To find out more about our services and how we can help you, why not book a free consultation. You can book online or call us on 020 7189 2400.

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