Use all your tax allowances – If not, why not?

Recent Government Budgets and Autumn Statements have reinforced the ‘freeze’ on some tax allowances and reduced several others. Those are effectively increases in tax for almost all ordinary taxpayers for this and future tax years (and indeed have been extended until the 2027/2028 tax year), which means that more and more people are having to complete Self-Assessment tax returns.

Therefore, with the consequent increase in the number of higher rate taxpayers, there comes the need for people to obtain the appropriate financial advice. There is highly likely, as a result of portfolio changes, to be an increase in the people incurring Capital Gains Tax (‘CGT’) under their actively managed investment portfolios, (and that are not already held in an ISA wrapper). Those people are likely to need specialist help with how to manage those portfolios more efficiently moving forward.

In order to help you with what this means in broad financial planning terms, we have outlined below the tax regime as it stands at the moment, and potentially how you could benefit from the available tax incentives. We would however caveat that with the important fact that tax planning does vary with the circumstances of each individual and tax laws are highly likely to change again in the future.

Annual taxable income threshold is £125,140

Income above that amount is subject to an additional rate of income tax of 45%.

Individuals that earn between £100,000 and £125,140 are already in effect paying 60% income tax, due to the fact that for every £2 of salary above £100,000, the Personal Allowance is reduced by £1.

Frozen tax thresholds

As mentioned above, the personal income tax allowance, higher rate income tax threshold and main national insurance thresholds are set to remain frozen at the same monetary figures until 5^th April 2028.

As everyone’s earnings increase over the next few years those ‘frozen’ tax bands will mean that more and more individuals will fall into the higher rate tax brackets. The net effect is a reduction in real disposable income.

Share dividend tax-free allowance

This was reduced from £2,000 to £1,000 with effect from April 2023 and is due to be reduced again from April 2024 to just £500. Again those assets not held in an ISA wrapper are likely to suffer additional tax.

Capital Gains Tax (‘CGT’) allowance reduction

This allowance was also reduced from £12,300 to only £6,000 with effect from April 2023 and is also set to be further reduced, to only £3,000, from April 2024.

CGT is a tax on the profit (i.e., the ‘capital gain’) made from an asset that has increase in value and is usually levied when that asset is sold. It applies to assets such as property (that is not the main residence); investment not held in tax-efficient accounts (such as ISAs) or business assets.

The rates and rules for CGT are quite complicated. They are different depending on whether an individual is a basic or higher rate taxpayer and also between property and non-property assets. In addition, individuals who sell their business may be able to benefit from Business Assets Disposal Relief.

As a result of these frozen (effectively reduced), allowances individuals obtaining the best financial planning advice is of paramount importance to ensure that they are using a suitable combination of tax wrappers where tax allowances are limited, such a ISAs, Pensions, Dividend Allowance, Venture Capital Trusts subscriptions and also Onshore and Offshore Investment Bonds (Qualifying Life Policies) where appropriate.

Some, often overlooked, tax allowances

Personal savings allowance

The PSA allows you to earn interest tax-free on your savings with the limit dependent on your marginal income tax rate. There is a £1,000 tax year allowance for Basic Rate (i.e., 20%) taxpayers and a £500 tax year allowance for Higher Rate (i.e., 40%) taxpayers. There is no PSA for Additional Rate (i.e., 45%) taxpayers.

Premium Bonds

Premium Bond prizes are tax-free and the current, January 2024, rate is 4.65%. The current odds of winning a prize in the monthly draw are 21,000 to 1 for every £1 bond, effectively meaning that you really need to hold a significant amount to a reasonable chance of winning and achieving that rate, although a number of small pries do add up over time. Individuals can save up to £50,000 each in Premium Bonds.

Gifting

Individuals are also able to gift up to £3,000 each tax year tax free and there is no limit on tax-free gifts to your Spouse. Regular tax year gifting reduces the value of an individual’s estate for liability to Inheritance Tax (‘IHT’) purposes, as well as helping out others.

Pensions

In the Spring Budget of 2023 the annual pension allowance was increased from £40,000 to £60,000 giving many who have not used up their allowance the opportunity to reduce their tax liabilities by moving across more of their income to their pension.

During the last year or so of inflationary pressures, being able to effectively ‘put aside’ regular income into your pension is not possible, or indeed the right course of action for everyone. It is however something for everyone to consider.

Paying more into your pension is the simplest way to make the most of the Pension Tax Allowance and the rules on pensions are fairly straightforward provided that your contributions stay within HMRC’s limits. However, those HMRC rules do become a little more complicated if you get close to, or exceed, the limits.

The tax relief granted on pension contributions is at the rate that an individual pays income tax. The net contribution that you pay is topped up by the Government/HMRC with every £800 contribution being increased by £200 basic rate tax relief to a gross pension contribution of £1,000.

For Higher Rate Taxpayers they receive another £200 of tax relief claimed through their annual Self-Assessment Return, rather than at source.

All growth achieved through a pension plan is tax-free and the retirement benefits that you receive will depend upon a number of factors, including the value of your plan when you decide to take benefits. Most personal pension plans are invested in unit linked risk assets/investment funds that are not guaranteed, and the underlying values can go down as well as up. There is no guarantee that the plan value will be greater that the gross contributions paid in.

Pension contributions limits

For the majority of individuals the most that can be contributed tax-efficiently into a pension is capped at £60,000 per tax year. That limit includes the value of any contributions paid by an Employer.

Although the £60,000 cap exists, the actual amount anyone can pay into their pension is linked to what they earn, and for those earning more than £60,000 p.a. they can usually contribute up to that maximum amount.

For those with no earnings, they are allowed to contribute a ‘de minimis’ amount of £3,600 a year. Due to HMRC rules those ‘non-earners’ can make a net contribution of £2,880 a year with HMRC adding £720 of basic rate tax relief to give the total £3,600 gross figure.

For those that earn more that £200,000 they should be aware that the amount they are able to pay into a pension ‘tax-efficiently’ could reduce as the ‘Tapered Pension Allowance’ for high earners will apply. There is now no limit to the total amount an individual can invest on a tax efficient basis into a throughout their lifetime.

If they are able, every individual should look to maximum pension allowances to the full effect if possible, using up any unused allowances for each tax year. If an individual has the capacity to invest the maximum annual allowance than it is usually in their best interests to do so.

Pension carry forward

Under current HMRC pension rules there is the facility for those who wish to pay more than the £60,000 annual contribution limit by utilising the ‘carry forward’ rules.

Pension carry forward allowance allows individuals to utilise any unused pension allowance from previous tax years and is therefore useful for those that have used up all their allowance for the current tax year. In that situation individuals can make further tax efficient pension contributions that exceed the current tax year’s allowance.

This is best illustrated with an example:

2023/2024 Maximum allowable pension contribution made: £60,000

(Any earnings above that pension contribution could be potentially subject to income tax)

Previous tax year’s unused allowances (i.e., carried forward):

2022/2023:                                       £10,000

2021/2022:                                       £20,000

2020/2021:                                       £20,000

Total unused allowances               £50,000

Total 2023/2024 pension contribution allowance: £110,000

However in order to make that £110,000 contribution the individual would need to be earning £110,000, because their current year’s earnings set the limit for how much can be used from all four (previous) years.

However if you have exceeded your annul pension allowance and used up all your carry forward from the previous three tax years, the next tax efficient planning aspect to consider would be ISAs

One of the main benefits of pension is that the money that you initial invest can be free of tax, however and conversely, when you come to draw on your pension for retirement income purposes, that income may then likely be subject to income tax, excluding the 25% tax-free Pension Commencement Lump Sum, noting that there currently is an overall maximum of £263,275 that can be extracted tax-free as lump sum or income.

Stocks & Shares ISAs

The tax rules on ISAs work in reverse to pensions effectively. To clarify individuals will have already paid income tax on the monies they then invest into an ISA, and therefore to ‘offset’ that they will not be liable for any income tax or capital gains tax arising from their ISA investments, if and when they sell them.

Stocks & Shares (or Investment) ISAs are free of Capital Gains Tax and Income Tax and can contain Company shares, Corporate Bonds, Government Bonds, Investment funds and Unit Trusts

Anyone over aged 18 or above can invest up to £20,000 each tax year in a Stocks & Shares ISA, less any amount that you have paid into a Cash ISA in the same tax year. As long as the ISA remains invested it will stay active, rather than terminating at the end of the tax year, like an annual allowance.

AIM portfolios

In addition to the more traditional investments mentioned above, Stocks & Shares ISAs can hold a portfolio of AIM (Alternative Investment Market) listed shares. The AIM is a London Stock Market for shares in small and medium size companies, and the market listed companies currently have an average market capitalisation of approximately £80 million.

When an AIM portfolio is held for 2 years it effectively becomes free of Inheritance Tax and means that these portfolios can be passed onto dependents with no IHT liability.

However, as smaller-cap companies, AIM listed companies are higher risk investments than those quoted on the main LSE markets, and they are also subject to lighter regulation.

General Investment Accounts

For those individuals who have utilise both their Pension and ISA allowances they could next consider General Investment Accounts (‘GIAs’) together with onshore or offshore bonds, although whether they are all used depends on their personal circumstances.

GIAs are investment accounts held outside of a Pension or ISA tax wrapper and are subject to tax, meaning an individual could  be liable for CGT on any capital gains made that exceed the CGT allowances. Also, an income tax liability may arise on any income received and for higher or additional rate tax on any dividends paid out and that exceed the dividend allowances.

Having said that, GIAs can be a useful wrapper tool to make use of those allowances each tax year.

The CGT rate on GIAs for basic rate taxpayers is 10%, significantly lower than the 20% rate for higher rate taxpayers.

Again, the Dividend tax rate is only 8.75% for basic rate taxpayers but a high 33.75% for higher rate taxpayers and even higher 39.35% for those that pay the additional 45% tax rate. As a result, GIAs are more suitable for basic rate taxpayers, who will benefit from the lower tax rates.

Onshore and Offshore Bonds

These types on Investment Bonds (or Qualifying Life Policies) are more suitable investments for higher and additional rate taxpayers.

These types of Investment Bonds can hold a wide range of assets within them, such as shares/equities, corporate or government bonds and commercial property. Although not subject to CGT they are subject to income tax.

However, under HMRC ‘tax deferred’ rules an individual can withdraw 5% pf the original capital invested each policy year without having to face immediate tax charges. That rule is cumulative meaning that if you do not withdraw the 5% each year it will build up and can be used to withdraw more than the 5% in later years.

A further aspect to these Bonds, and one that can be used for Estate and IHT planning, is that they could be encashed by a family member/dependent who is a nil or lower rate taxpayer, making them tax efficient in those circumstances.

Venture Capital Trusts

VCTs might be a suitable option for some individuals, and particularly for those that have used up their Pension, ISA, and other tax allowances, and still have a tax liability to offset.

VCTs are listed on the LSE and invest in small, unquoted, and higher risk ventures/companies.

They offer a number of tax efficient benefits for those that have the risk profile and tolerance to invest in such companies. VCTs offer 30% tax relief of the amount subscribed per tax year for investors who subscribe for new shares prior to the VCT being listed. The only requirement is that the VCT shares must be held for 5 years, otherwise the 30% income tax relief would have to be paid back to HMRC.

For example, a £20,000 VCT investment could reduce an individual’s income tax liability by £6,000. As the maximum tax relief available is £60,000 (i.e., based on a £200,000 investment) then a VCT subscription could eliminate an individual’s total income tax bill.

In addition, VCTs are not liable for any dividends they pay or subject to CGT on their eventual sale.

VCTs are high risk investments reflecting the nature of the companies they hold in each trust portfolio. However that risk is offset to some degree by the effect of diversification, as each trust invests in a range of ventures and companies and those across a range of sectors.

For those individuals who are willing to accept the risks, and that have the financial capacity to withstand potential investment losses, VCTs have excellent financial planning benefits.

Enterprise Investment Schemes

EISs investments also offer 30% of investment in tax relief on subscription and even higher other tax incentives but are even higher risk than VCTs.

In making an EIS investment an individual could potentially defer any CGT liability that may have been incurred from either selling other investments or a second home. However, unlike VCTs, EISs can fall outside the scope of IHT as long as the investment is held for at least 2 years.

EIS investments have a higher maximum investment limit than VCTs, at up to £1 million. Although some EISs are quoted on the AIM market, most are unlisted companies and therefore can be more difficult to sell. That limitation, along with their very high risk characteristics, make EISs inappropriate for many investors, and those with a limited amount of assets.

Spouse’s allowances

Lastly, if investment returns are eroded by tax than an individual could consider using their Spouses’ allowances. If a spouse in a non-income earner, and therefore unable to use their allowances, they could reduce the main income earning spouses tax payments. An example of this would be the transfer off 10% of their personal allowance to the income earning spouse to increase their tax band.

When establishing investments married couples should attempt to maximise their combined allowances by taking advantage of any difference in their individual tax bands. It should be noted however that as is the cash with financial planning in general, this can be complex, and all individuals should see the advice of a reputable Financial Adviser.

 Article by Mark Howse, Senior Financial Planner, Roberts Boyt Limited on 3^rd January 2024. E & O E.

Sources:

• nsandi.com ‘Premium Bonds,’ December 2023.