Tax is a complicated part of your financial planning, one with a lot of misconceptions and one where the rules change on a regular basis.
Here are our most common themes when talking to you about your tax planning:-
How much Income Tax should I pay?
Each individual can earn income of £12,500 per year before they have to pay any tax, thins known as the Personal Allowance. For most people employed full time this amount is used up and they pay some tax, 20%, 40% or 45% on the remaining income on a tiered basis. These are known as tax bands with 20% being the basic rate band, 40% being the higher rate band and 45% being the additional rate band.
The rules are slightly different in Scotland. Higher earners also begin to lose personal allowance once they have income over £100,000. The Personal Allowance is reduced by £1 for every £2 they earn over £100,000 meaning that people earning over £125,000 have no Personal Allowance at all, although it is sometimes possible to get some or all of it back through effective tax planning.
What is Pay as you Earn (PAYE)?
Most employees pay tax through PAYE meaning that their employer deducts tax directly from their wages before they are received.
This system generally suits both parties as HMRC receive their tax more quickly than waiting for an annual return and the employee does not have to complete a tax return unless they have other reasons to do so such as the high income child benefit charge.
Who has to Complete Self-Assessment?
Some earnings aren’t covered by PAYE which means people who receive this untaxed income must complete self assessment return to HMRC. Online tax returns are due by the next 31st of January after the end of the tax year in which the income was received. The tax is due at the same time although if HMRC believe the tax will be due each year and exceeds certain amounts they may also require you to make a payment on account against the liability for the following year.
Directors and Partners in businesses must complete Self Assessment, as must people who are self employed or sole traders. People normally paid via PAYE must also complete a return of they receive untaxed income such as rental income from a buy to let property, or if they have triggered the higher income child benefit tax charge.
There can be times when completing self assessment results in someone actually receiving money back such as if they are higher or additional rate taxpayers making contributions into a pension from net pay.
How can I build a financial plan around Income Tax?
Most employees have little or no flexibility over the structure of their income. If you are paid by PAYE you can potentially take some steps to plan you income, especially if you are a higher earner. Making pension contributions or charitable donations can be used to ‘reduce’ your total income and take you back under trigger points such as the high income child benefit tax charge or the tapering of the personal allowance.
Business owners tend to have more flexibility in how they plan their income, often only using the tax free personal allowance for PAYE income before drawing dividends on amounts over this.
This allows them to make use of the tax free dividend allowance before paying tax at a lower rate than they would on PAYE income. Dividends are also exempt from National Insurance therefore increasing net pay but the downsides must also be considered as paying national insurance is required to qualify for certain state benefits such as the State Pension.
What is Capital Gains Tax?
Capital gains tax is payable on investment gains. It includes residential property but your main residence is exempt so you do not pay capital gains tax when selling house that you have lived in for the full time that you have owned it.
Each individual has an annual amount of gain that is exempt from any tax, with gains in excess of this amount being taxed depending on the type of asset and the tax status of the person disposing of the investment. Investments held within an ISA or a pension are exempt from capital gains tax.
There are also more sophisticated allowances and exemptions, such as Entrepreneur’s Relief, that are aimed at ensuring people are incentivised to invest money into new companies that can create jobs and boost the economy.
Do I need to do any Inheritance Tax Planning?
With increasing house values more people are finding that they need to consider Inheritance Tax when analysing their legacy planning.
Tax Planning with Pensions
Pensions are a great tool for tax planning, both when paying money in and when drawing money out. Making contributions to a registered pension scheme normally result in an immediate 25% benefit as the government top up your contributions with the tax that you have already paid.
The contribution effectively reduces your overall income and higher earners can also benefit from additional tax relief via self assessment. These benefits are there to incentivise people to save for their retirement. Since the pension flexibility rules came into force far fewer people are buying annuities and therefore taking money out of pensions in retirement can be structured to be more tax efficient.
Such a strategy is known as tax efficient pension drawdown and involves balancing the 25% of the pension that is available tax free with the taxable element to ensure that total taxable earnings do not exceed the Personal Allowance. In some cases, people are able to structure income of £15-£20,000 per annum without paying tax for a number of years.