How you can beat Jeremy Hunt's income tax trap
It was the Autumn Statement last year when Jeremy Hunt announced that the additional rate threshold would be lowered from £150,000 to £125,140 – pulling another 232,000 workers into the top rate of tax.
If your earnings are in the range between those figures then, come April 6, you will tip into the 45 per cent bracket, costing you on average £621 in extra tax per year. Those already earning over £150,000 will lose £1,256 on average.
Overall the new threshold is expected to net the taxman an additional £420m in the next tax year.
You face a different issue if your annual income is between £100,000 and £125,140. Then you could find yourself caught in the 60 per cent trap.
For every £2 you earn between £100,000 and £125,140, £1 of your personal allowance is taken away. The personal allowance, worth £12,570, is then fully withdrawn once the individual’s income exceeds £125,140.
Fortunately there are a number of ways to drop down a tax band. If you are a top earner then consider taking these steps in order to shelter your money from the taxman.
Increase your pension contributions
One of the best ways to reduce your taxable income is to boost your pension contributions.
Kate Smith, of pensions firm Aegon, said: “Paying pension contributions reduces an individual’s adjusted net income so that it falls into a lower tax band while still getting the benefit of tax relief at their highest marginal rate based on their gross salary.”
A worker with an income of £160,000 a year will pay 45 per cent tax on their £10,000 marginal income above the £150,000 upper threshold – keeping only £5,500 of it in their take-home pay.
By making a personal pension contribution of £10,000, they will become a 40 per cent tax payer. But they will still be entitled to 45 per cent tax relief on their £10,000 personal contribution. So they would give away £5,500 to get a pension contribution of £10,000 – resulting in a tax saving of £4,500.
“Depending on how the pension scheme administers pension tax relief, individuals may have to claim higher and additional rate tax relief via self-assessment from HMRC,” said Ms Smith.
“An alternative is to use salary sacrifice to pay pension contributions. This could increase an individual’s effective rate of tax relief, as the amount of salary exchanged for a pension contribution is not liable to income tax or National Insurance contributions, as it effectively becomes an employer contribution."
Up to £60,000 a year can be saved into a pension tax-free. This was increased from £40,000 in Jeremy Hunt's Spring Budget. Remember you could face charges if you contribute more than the lifetime allowance of £1.8m (up from £1.07m).
The disadvantage is you cannot access the money saved in your pension until age 55 (57 from April 2028). It also reduces your take-home pay.
Use workplace benefits
If you cannot afford to cut your take home pay, check if your employer offers any benefits you could opt into instead.
Shaun Moore, of investment firm Quilter, said: “Other than just upping pension contributions through salary sacrifice, employers may also offer other benefits, such as childcare vouchers, bike-to-work schemes, and car finance schemes, which can be taken in exchange for a portion of your salary. This salary sacrifice helps to reduce your taxable income.”
Donate to charity
Another way to reduce your taxable income is by making donations to charity.
You could give regularly to charity through payroll giving, where your employer makes the donation from your pay before working out tax, or you could use Gift Aid to make a donation.
Through Gift Aid, the charity can claim back from HMRC the basic rate tax you have paid on the amount of the gift. As an additional rate taxpayer you can also claim back extra tax from HMRC (the difference between the 20 per cent rate and the higher rate you pay).
Remember to only give away what you can afford – as donations cannot be retrieved later.
Protect your savings
Basic rate taxpayers can earn £1,000 of interest from their savings tax-free, while for higher rate taxpayers the allowance is £500. But when you become a 45 per cent taxpayer, the personal savings allowance disappears.
Losing the allowance means you will pay £360 a year in tax on a £20,000 deposit – three times what a higher rate taxpayer would pay.
This is why you should maximise the £20,000 on savings placed in an Individual Savings Account (Isa). Any income earned in an Isa is free from dividend tax or capital gains tax.
If your portfolio far exceeds your £20,000 allowance then you should prioritise moving your dividend-paying investments into your Isa so that any dividends earned are tax-free. Remember that the dividend tax-free allowance will halve in April from £2,000 to £1,000, and then to £500 next year, meaning your dividend tax bills could rise.
Transfer assets to your spouse
If your spouse is in a lower tax band, then you can potentially make a huge tax saving by moving assets into their name.
Dividends, for example, are taxed at 8.75 per cent for basic rate taxpayers whereas additional rate payers are charged a huge 39.35 per cent. Basic and higher rate taxpayers also have the savings allowance, which reduces the likelihood of them paying tax on your savings pots.
Rents are treated as taxable income so it may make sense to put these in the lower earner’s name as well.
Assets transferred between spouses are free from inheritance tax and capital gains tax, so there is no additional cost.
Bring payments forward
The end of the tax year is fast-approaching but there may still be enough time to lower your tax band by bringing forward any bonuses or dividends you are due.
Mr Moore said: “While it might be a little late this year, if you are self-employed you could consider taking part of your remuneration as dividends and bringing forward scheduled payments to the current tax year if you are likely to move into a higher tax band in April. The tax-free dividend allowance is also higher this tax year.
“Similarly, if you receive income from a pension in drawdown, bringing some of it forward to this tax year may reduce the tax paid if you expect higher top earnings in the next tax year.”
Tax relief from investments
There are special tax reliefs available for investors brave enough to take a punt on young businesses. Venture capital trusts and the Enterprise Investment Scheme both offer up to 30 per cent tax relief, provided you hold them for five or three years respectively. Meanwhile the Seed Enterprise Investment Scheme offers 50 per cent tax relief.
Venture capital trusts pay their returns in tax-free dividends and give investors access to privately owned businesses. But because of this they are also higher risk.
“You should only invest in them if they are suitable for your investment purposes and risk appetite and they are not right for everyone,” Mr Moore said.