Last reviewed 10 January 2020
The key to tax planning is to ensure that all allowances are utilised and that you do not unnecessarily exceed tax thresholds.
To plan for tax it is first necessary to understand your tax threshold so you can plan ahead.
The rates for 2019/20 are:
England, Wales and Northern Ireland
20% Basic Rate
£0 to £37,500
19% Starter Rate
£0 to £2,049
40% Higher Rate
£37,501 to £150,000
20% Basic Rate
£2,050 to £12,444
45% Additional Rate
Earnings over £150,000
21% Intermediate Rate
£12,445 to £30,930
41% Higher Rate
£30,931 to £150,000
46% Top Rate
Earnings over £150,000
The various tax rates are applied to the annual earnings above the PAYE tax threshold up to the amount shown. So, for a person in England earning £55,000 the tax will be as follows:
National Insurance will also be charged in addition to the income tax.
Persons in self-employment may be able to arrange for income to be deferred into another financial year, brought forward or it is equalised between their married or civil partners to ensure that thresholds are not exceeded.
Where a spouse or partner is paid, it is important that real work is undertaken for any income earned. Income cannot be split artificially. But, where income is rental income the proportions received can be altered by changing ownership shares and also interest can be earned by the lower paid person rather than the higher paid person to ensure the interest income is earned by the lower paid person (but see below). When income is deferred to another year the rules regarding accruals need to be adhered to.
Families with child benefit lose the benefit by 1% for each £100 income exceeds £50,000. Child benefit for one eligible child is £1,076-40 per annum. If £50,100 is earned £10 needs to be repaid as a tax charge. If £51,000 is earned, £107 needs to be repaid. When earnings reach £60,000 all child benefit received needs to be repaid.
The £12,500 personal allowance is reduced by a £1 for each £2 earned over the £100,000 threshold. Thus, once gross total income reaches £125,000, the tax-free personal allowance has been completely abated. This creates a high 60% effective tax rate in this band due to the reduction of the personal allowance. Again, reducing income to below the £100,000 limit is tax effective.
As an example, if a person earns a total of £112,500. The personal allowance is £12,500 making taxable income £100,000. Tax is applied as follows:
£37,500 @ 20% = £7,500
£62,500 @ 40% = £25,000
Total tax = £32,500
If the individual earned an extra £10,000 the total income is £122,500. The personal allowance is reduced by £5,000 to £7,500. Tax is then charged as follows:
£37,500 @ 20% = £7,500
£77,500 @ 40% = £31,000
Total tax = £38,500
So, for an extra £10,000 in income an extra £6,000 in tax is paid, a rate of 60%. Clearly this high marginal rate is to be avoided as much as possible.
For the last three-or-four years savings interest has been paid without any tax deduction. A basic rate taxpayer can earn £1,000 in interest without paying tax. A higher rate tax payer can earn £500 before tax is payable, but an additional rate taxpayer pays tax on all interest earned. This applies to all interest, not just bank interest. It includes interest received from credit unions, peer to peer lending and any other source. Thus, if you are earning 2% interest a basic rate taxpayer can invest £50,000 before any tax is payable (2% of £50,000 is £1,000). A higher rate taxpayer can invest £25,000 before tax is paid.
When calculating the total tax received any tax-free accounts (such as a cash ISA) are excluded from this and do not count toward the savings interest limit.
Taxpayers in Scotland pay different rates of tax and the example below is based upon an English taxpayer.
For example, a person earning £50,000 and also received £1,000 in savings interest. The addition of the interest pushes the taxpayer into the higher rate band. Thus, only £500 is tax free and £500 will be subject to the higher rate.
It should also be noted that National Insurance is not charged on interest earned. So, a genuine loan made to a company that you own can produce interest income that is not subject to National Insurance and may benefit from the interest earnings threshold. It is likely that the company will be classed as a ‘close company’ and special rules apply to close companies. The company must deduct 20% tax before making the interest payment and account for that tax to HMRC. The interest expense is deductible by the company when it is calculating its taxable income.
Dividends can be received if you own shares in a company. It can be tax effective to provide your services through a company and to be paid in a combination of salary and dividend. A problem can, however, arise where services are supplied to just one customer. HMRC may contend that you are in fact an employee not a self-employed contractor (the IR35 legislation may be applied by HMRC).
Assuming that the IR35 rules do not apply there is a specific tax regime that applies to the dividends that are received (and this applies to all dividends, whether received from a company you own, or from shares held as an investment in a large company). First, no National Insurance applies to the dividend received. Secondly, in respect of income tax, no tax applies to the first £2,000 received. The tax that applies to amounts in excess of this threshold is:
Basic rate 7.5%
Higher Rate 32.5%
Additional rate 38.1%
For example, if £3,000 in dividends is received, the first £2,000 is not subject to tax. If other taxable income received is £30,000 the dividend income is added to the other taxable income to give total taxable income of £33,000. As the income is in the basic tax band, 7.5% tax is due on the £1,000 of dividends received in excess of the basic tax band.
It must not, however, be forgotten that the UK corporate tax rate of 19% will apply to the profits of the company and it is from these profits that the dividends will be paid. Further advantages of dividends in your own company is that they can be ‘drip-fed’ to the shareholders so that they are received when the shareholder has lower earnings and also when retired when little or no other income is being earned. In addition, if a spouse or partner is a shareholder as well as the business operator being a shareholder, the dividends will be paid to both shareholders to utilise both parties’ thresholds.
Reducing taxable Income and utilising allowances and reliefs
There are a number of ways to reduce taxable income. The first is to employ a spouse or partner in the business and pay them a salary. This will reduce the income of the main earner and will increase the income of the other party. This will equalise the amounts paid and can be used to ensure that incomes are below the thresholds described above. It should be noted that the employment must be real. If HMRC suspect that the salaries are not for a real employment they may attribute the income to the main earner.
Making the most of any lower rate taxes that can be utilised is especially beneficial, especially if they avoid incurring National Insurance. Consequently, arranging to receive interest or dividend income is effective tax planning. Lending money to your own company (for example to enable it to buy assets) allows you to receive interest from the company. Also, if there is spare cash it can be invested in interest bearing accounts; interest can be earned without tax being paid where the amount received is below the thresholds given above.
There are a number of investment vehicles that have tax free status. For example, the interest earned on a cash ISAs is tax free. For a person on a basic rate of tax the savings rate you achieve (if you pay tax on the interest) has to be 25% higher than the cash ISA rate to compensate for the tax payable on the non-ISA account. For higher rate taxpayer the rate has to be 66% higher on the normal interest-bearing account to exceed the cash ISA rate. Up to £20,000 a year can be invested in an ISA.
Enterprise Investment Schemes (EIS) give a 30% tax reduction on investments and a capital free gain on a sale after three years. A 50% relief on up to £100,000 can be obtained on Seed Enterprise Investment Schemes (as well as a CGT exemption on shares held for three years). Reliefs are also available for Venture Capital Trust investments, Social Investment Tax Relief and Investors Relief for qualifying shares. Specialist advice needs to be taken if such investments are being considered.
A further planning tool is to maximise deductions. Any expenses that are incurred before the year end can be deducted from the gross income to reduce the amount subject to tax. Where, however, a capital item is purchased only the depreciation amount (and this is time apportioned if the asset is acquired in the year of assessment) can be claimed to reduce taxable income.
A pension contribution will reduce the amount of taxable income and is a cost-effective way of both reducing tax and providing for the future. The Annual Allowance that can be contributed to a pension fund is £40,000 in a year with a Lifetime Allowance of £1,055,000. It should be noted, however, that for every £2 the adjusted income goes over £150,000, the annual allowance for that year reduces by £1. The minimum reduced annual allowance is £10,000. Calculating the adjusted income is complicated so it is prudent to get some advice if income is approaching that amount. Charitable contributions also reduce taxable income, so it is worth reviewing bank statements to calculate all the charitable contributions that have been made in the year.
There are numerous ways to reduce tax payable. It is necessary to plan ahead to ensure that all reliefs and allowances are taken. It is also prudent to take specific advice to ensure that the reliefs are available in your specific circumstances.