Saving tax legitimately

Saving tax doesn’t have to be complex; it shouldn’t be confused with big corporations using complicated tax avoidance schemes, or individuals taking the odd cash-in-hand job (assuming it is legitimate not to pay tax!) but actually it is about identifying things that every person can use.

When “Cameron Gate” hit the headlines journalists were excited because they thought they had something that would topple the government. We saw Sigmundur Gunnlaugsson the Prime Minister of Iceland resign, would the same happen to David Cameron?

Although it wasn’t the best example of PR, once the dust settled it became clear that there was nothing wrong with David Cameron’s tax affairs. If anything it highlighted that there are many ways we can legitimately save tax.

Saving tax doesn’t have to be complex; it shouldn’t be confused with big corporations using complicated tax avoidance schemes, or individuals taking the odd cash-in-hand job (assuming it is legitimate not to pay tax!) but actually it is about identifying things that every person can use.

In this blog we explore some of the more obvious ways of saving tax. It is worth adding this an overview and there are many other examples that could be used to save tax.

Pension Savings

There are numerous tax advantages to pensions:

  1. Pension contributions receive tax relief. So for example if I want to pay £100 each month then as a basic rate tax payer I receive 20% tax relief into my pension meaning I get £125 invested. You could argue that you are guaranteed an extra 20% a year for doing nothing! It’s a bit more complex for higher rate tax payers because they can claim an extra 20% back through their tax code. If they put that back into the pension that’s a 40% uplift! There is not much that guarantees at least a 20% uplift each year! (Unless the tax rates changes!)
  2. Investing in a pension carries many tax advantages:
    1. Investments grow tax-free
    2. Up to 25% of the pension fund can be taken at retirement tax-free
    3. On death the pension fund does not form part of the estate for inheritance tax purposes, and potentially the whole fund can pass to a chosen beneficiary tax-free
    4. The pension fund shouldn’t form part of any means testing when it comes to long term health care or unemployment benefits (although any income may form part of the calculation)

Of course there are downsides to pensions which is the quid-pro-quo for having the generous tax advantages. So for example, income is taxable, the full fund can be withdrawn but 75% of it is taxable, (and in the tax year benefits are taken this could move a nil or basic rate tax payer into the higher rate tax bracket so 40% tax could be charged. Therefore, planning when and how much should be taken is important to avoid additional tax charges).

The maximum level of pension savings is now £1m, after which the fund is taxable when the excess is taken (but many won’t reach this level), and benefits are locked in until age 55.

Pension Savings: Salary Sacrifice

Salary sacrifice is a little known benefit but can be beneficial for both basic and higher rate tax payers in enhancing the contribution that is paid to their pension. For this example, we want to focus on higher rate tax payers and those who may see child tax benefits being cut at £50,000.

Taking an example of someone earning £52,000, as the earnings breach the £50,000 child benefit limit these are cut to reflect this. Effectively creating a disincentive to earning over £50,000. There is a simple and effective way to avoid this.

Using salary sacrifice if pension contributions of 5% were paid both by the employer and employee and national insurance contributions were reinvested into the pension, then the salary reduces to £49,310.34. This means that the full level of child benefits can continue because the earnings have now dropped below £50,000.

Additionally, with the salary sacrifice the take home pay is the same as it would be at £52,000 (with the pension contribution) but an additional £460 is paid into the pension.

Effectively there are two wins:

  1. The pension contribution increases from £5,200 to £5,660 at no extra cost, so an additional near 1% goes towards pension savings
  2. Earnings drop below the £50,000 threshold ensuring child benefit isn’t reduced

Special note: Salary levels are often used to calculate many state benefits such as Statutory Maternity Pay, Statutory Sick Pay, Jobseekers Allowance etc. By reducing your Salary this could impact upon the benefits you could receive. Furthermore, reducing your salary could have an adverse impact on your ability to borrow, for example Mortgage and Loans as your salary is effectively reduced for calculation purposes.

ISA

An ISA for some can be seen as something to work alongside the pension. We don’t have the details on the proposal of the new ISA so this just looks at what we have today.

All investments grow tax-free, income is tax-free, there is no restriction on when money is taken out and there is no limit on how big the fund can grow to.

The key advantage is the tax-free income because it can reduce the effect of tax in retirement.

But there are disadvantages; for example, the money built up forms part of the estate for inheritance tax planning, contributions are restricted to a maximum annual limit and it can form part of means testing for long term health care and unemployment benefit.

Up to £1,000 savings interest tax-free

In the past with cash savings (which were not in an ISA) tax at 20% was taken immediately. Higher rate tax payers would pay according to their level of tax.

For basic rate tax payers, they can now earn up to £1,000 interest with no tax, and higher rate tax payers have a limit of £500. Assuming a 2.2% cash savings plan this means a basic rate tax payer could invest up to £45,454 and for higher rate £22,727 before any tax is paid.

Some have said this replaces an ISA but if income was based on interest then it would be minimal amounts. Similar to an ISA there are the same disadvantages around inheritance tax and means testing.

Capital gains tax

When selling investments held outside of an ISA or pension, capital gains tax may be payable. The annual exemption of £11,100 can reduce down or negate any potential tax. Joint investments mean spouses can double the allowance creating potentially another source of tax efficient income.

Again like an ISA and the new savings allowance, there are disadvantages in relation to inheritance tax and means testing, in that both these are included in those calculations.

Choosing what is right for you

It is very easy to consider these ideas in isolation; a pension for retirement, an ISA for savings etc but everything is interlinked.

Financial planning is the key to bringing this together. Whether this is done with or without advice this enables us to identify what we want, and then how we achieve this by using the most tax efficient “vehicles”.

Shininglights has a bias to seeking advice because we believe planning can be complex. These examples are not exhaustive, and can be used in different ways to match individual requirements. There are other options for example relating to inheritance tax planning, tax efficient investments like VCTS and EIS (which we would explore in separate blogs) and all of these can be considered as part of delivering on our plans.

What disappointed journalists with “Cameron Gate” was that there was nothing ultimately wrong with what he did, and what they failed to capitalise on was how others could take note of what he was doing. But that was never going to be a good story!!!

The lesson from all of this is that there are many legitimate ways of saving tax but everything comes back to having a plan. The plan helps us to look for the best solutions to deliver on our goals to meet our investment needs, but also in the most tax efficient way.

Note: The Financial Conduct Authority does not regulate tax planning. All reference to taxation are based on the tax year 2016/2017 and is based on our understanding of current legislation, taxation law, HM Revenue and Customs’ practice, which are subject to change.

This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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