Thousands of people face bigger tax bills after being pulled into the higher rate income tax bracket – yet many are unaware of it because they don’t know where the 40 per cent band starts.
Less than one-third of people (31 per cent) polled by YouGov for Standard Life knew that the higher-rate tax threshold for 2013-14 is £41,450. Worryingly, 37 per cent thought the threshold was higher than it actually is.
It’s a misconception that could cost them dear, thanks to the phenomenon known as “fiscal drag”. This is the effect of a tax grab on middle earners that took effect on 6 April and which will see more than 400,000 more people join the 4.2 million who already pay higher-rate tax.
The basic rate tax band fell from £35,000 to £34,370 in the 2012-13 tax year and now rests at £32,010. The personal allowance (the amount you can earn without paying any tax) has risen from £8,105 to £9,440. However, this fails to make up for the reduction in the basic-rate band, and means the higher-rate band comes into effect for income in excess of £41,450 in 2013-14 instead of £42,475 in 2012-13.
What’s more, the higher rate tax threshold will increase by just 1 per cent a year in 2014-15 and 2015-16, below the rate at which earnings are currently increasing.
Being a higher-rate taxpayer does not just mean paying more income tax on your salary. Your income tax liability will also increase on your savings income, rental income and any investment dividends you receive. It will also mean that any capital gains tax (CGT) liability will be payable at the higher rate rather than the basic rate (28 per cent instead of 18 per cent).
So how can you reduce your higher-rate tax burden or even avoid being pulled into the higher-rate tax net at all? Here are a few options:
Save and invest wisely
Paying into a personal or employer’s pension scheme is the simplest way to minimise your income tax burden. It has the added bonus of boosting your retirement savings and reaping the tax benefits of investing in a pension scheme at the same time.
Pension contributions are either deducted by your employer before you are taxed, thereby reducing your taxable salary, or if you make the contribution out of net income, you will receive tax relief at your highest marginal rates from HMRC.
Basic-rate tax relief will be added directly to your pension, with higher-rate tax relief claimable through the tax return system. You can currently contribute up to £50,000 each tax year into a pension – falling to £40,000 a year next April – and might be able to carry forward any unused annual allowance from the three previous tax years.
If possible, realise gains up to the annual CGT exemption (currently £10,900) every year to further reduce your tax liability. If your annual gains exceed this, then making a single pension contribution at the same time as realising a large gain can help to prevent you from paying the higher rate of CGT. Your annual pension contributions effectively extend your basic-rate tax bracket by the amount you invest. This means you will pay a higher proportion or possibly all of your CGT liability at the basic rate.
Make the most of your individual savings account (Isa) allowance, too. Income or dividends received are free from income tax (although dividends have a 10 per cent tax deduction which can’t be reclaimed) and gains are free from capital gains tax. The allowance for 2013-14 is £11,520, of which £5,760 can be stashed away in a cash Isa.
Reduce your salary
This might not sound appealing, but there are ways you can reduce your salary without actually reducing your disposable income.
Salary sacrifice is an agreement with your employer to reduce your salary in exchange for additional benefits, such as pension contributions or child care vouchers. By reducing your salary you will save income tax as well as National Insurance (NI) contributions.
Under recent changes, new participants in the childcare voucher scheme – whereby you can buy vouchers for your childcare out of your pre-tax income – will only be able to claim back 20 per cent of their childcare costs up to £6,000 per child. However, this is still a welcome £1,200 saving for higher-rate taxpayers.
From January this year, households where at least one parent had income of more than £50,000 a year have their child benefit fully or partially cancelled out by a child benefit tax charge, but a salary sacrifice arrangement could help you keep some or all of your child benefit entitlement.
Manage your income
If your income fluctuates, you might be able to change the year in which income is generated or recognised. For example, if your income for this year looks set to come in at around £39,000 and there is talk of a £5,000 bonus, some of this would be taxed at 40 per cent. However, if the bonus is discretionary, you could reduce your tax liability by delaying your bonus or splitting it over two tax years. This can also be applied to one-off dividend payments.
Do you have a large personal pension fund and are nearing retirement? It might not be in your best interests to rush into buying an annuity since this could make you a higher-rate taxpayer for life. By making careful use of your 25 per cent tax-free lump sum and leaving your fund invested while drawing an income from it – what is known as income drawdown – you would be able to control the amount of taxable income you receive to ensure you do not fall into the higher-rate tax bracket.
Another way in which married couples and civil partners can manage their income is to transfer income-producing assets to the spouse with the lower tax liability. It is quite common for one spouse or civil partner to be a higher-rate tax payer but not the other, and assets can be transferred without any tax liability.
Lastly, consider reducing your taxable income by giving money to charity. Gift Aid allows charities to increase the value of monetary gifts from UK taxpayers by claiming back the basic-rate tax paid by the donor on the donation. As a higher-rate tax payer, both you and the charity benefit from Gift Aid donations. For every £100 you give, the charity receives £125 and you can claim £25 through your tax return, therefore reducing your higher-rate tax liability.
• Simon Wigglesworth is a chartered financial planner at Edinburgh-based Cornerstone Asset Management