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Danby Bloch: Understanding your clients’ income tax journey

Advisers need to be able to keep on top of clients’ income tax liabilities to ensure they get the best possible advice.

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There are lots of reasons why financial advisers need to know how to do income tax computations. You should not just leave such matters to accountants.

If you cannot carry out a tax computation, you will not be able to work out clients’ net incomes and therefore what they can afford. Nor will you really understand the implications of getting tax relief on pensions or the impact of tax-efficient investments generally.

You need to understand tax computations to be able to explain all these financial facts of life to clients; you cannot afford to hand it over to computer programs – even supposing they were all reliable.

The Professional Adviser’s Factfile contains two worked income tax and NIC examples for the current tax year. These will help you keep up to speed with the way the income tax system works this year and also help you explain it to clients.

Taxing earned and investment income

The first example is of a married man with a mix of different types of earned income and income from his investments. Income is taxed in different ways, so it is essential to know its order or priority for taxation.

If you do not understand the rules, you could end up making mistakes with the personal allowance and the higher rate tax calculation – leading you to underestimate or exaggerate a client’s tax bill and net income.

One way to think of income tax is to picture a person’s income as a journey.

The first part of the journey starts with the income that is set against their personal allowance of up to £9,440 (assuming they have one).

Any further income up to the next £32,010 is set against their basic rate tax band (normally 20 per cent, but 10 per cent for dividends).

Any income above £32,010 is taxed at the higher rate (normally 40 per cent and 32.5 per cent for dividends), until it reaches £150,000, above which there is the additional rate of tax (45 per cent and 37.5 per cent for dividends).

You have to start the journey with setting earned income – both employed and self-employed – first against the taxpayer’s personal allowance and then against their basic rate band and finally higher rate and additional rate tax.

In the example, the client’s earnings of £40,000 use up his £9,440 personal allowance, and then extend into his basic rate band to the extent of £30,560. If he had any taxable interest, that would kick in at this point – but he hasn’t. So the next tranche of income consists of his dividends.

The client’s earnings of £40,000 (personal allowance of £9,440 plus £30,560) have not used up his basic rate band of £32,560. There is still £1,450 of basic rate band left to fill. What’s more, he has made a gross pension contribution of £5,000 (net £4,000) and that has the effect of extending his basic rate band by £5,000 to £6,450 to give him the higher rate relief. This £6,450 is taxed at the 10 per cent dividend basic rate. And that leaves a further £3,550 to be taxed at higher rate – which is £32.5 per cent.

So his income is a total of £50,000 and his tax liability is £7,910.75.

The personal NIC calculation for the first example shows the breakdown between class 1 employee contributions as well as classes 2 and 4 self-employed contributions. This comes to a total of £2,561.85 personal NICs, without counting any employer contributions for the year.

EXAMPLE  –  Earned and investment income tax calculation

 Leon is a married man aged 47 has the following income in 2013/14:

  • Profit from self-employment of £25,000,
  • Employment earnings of £15,000
  • Dividends plus tax credits of £10,000.

He makes a personal pension contribution of £5,000 gross, i.e. £4,000 net of basic rate tax. Leon is not contracted out of the state pension.

Tax calculation Earnings Dividends Total

 

£

£

£

Income

40,000

10,000

50,000

Less: Personal allowance

(9,440)

(9,440)

Taxable

30,560

10,000

40,560

Basic rate on earnings:

£30,560 @ 20%

6,112.00

6,112.00

Basic rate on dividends:

£6,450 @ 10%

(£32,010 + £5,000*–£30,560)

645.00

645.00

Higher rate on dividends:

£3,550 @ 32.5%

(£10,000–£6,450)

1,153.75

1,153.75

Total tax (before deduction of tax credits and other amounts paid)

6,112.00

1,798.75

7,910.75

* Basic rate relief is given at source for the pension contribution. Higher rate relief is given by an extension of the basic rate band by the amount of the gross contribution.

 

NIC calculation Class 1  Class 2 Class 4 Total

£

£

£

£

 

Employment earnings:

£7,245 @ 12%

(£15,000–£7,755)

869.40

869.40

Self-employed earnings:

52 weeks @ £2.70

140.40

140.40

£17,245 @ 9%

(£25,000–£7,755)

1,552.05

1,552.05

Total NICs

869.40

140.40

1,552.05

2,561.85

(Source: The Professional Adviser’s Factfile, Taxation)

Taxing employment income

The second example focuses on the income tax position of an employee whose income of £160,000 is wholly derived from her employment. It shows how, at that level of income, the client has lost all her personal allowance and pays tax at all three rates: basic, higher and additional.

The formula for calculating the withdrawal of the personal allowance on income of over £100,000 is to deduct from £9,440 an amount equal to 50 per cent of the individual’s income over £100,000. In this woman’s case the excess income is £60,000 and half of this amount is £30,000 – far more than the £18,880 (£9,440 x 2) at which the personal allowance is totally withdrawn.

But if she had come within the income band of £100,000 to £118,880, say at £110,000, her marginal tax rate on any extra income would have been 40 per cent higher rate tax. And then on top, for every £2 of extra income she would have lost £1 of her personal allowance adding an extra 20p to her tax bill – making a total marginal rate of 60 per cent. Of course for such an individual, the rate of tax relief on a pension contribution, interest payment or charitable donation would also be 60 per cent within this £18,880 band of income.

Working through some tax computations of this kind every year will ensure that you really understand the tax system and can make a real difference to clients by explaining it clearly.

Danby Block is editorial director at Taxbriefs

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The Professional Adviser’s Factfile is the essential sales aid for busy financial advisers. Factfile supplies monthly updates, targeted statistics and concise explanations of core concepts so that you can focus on providing quality advice. Readers of Money Marketing who are new subscribers can order Professional Adviser’s Factfile for a 10% discount using promo code ARTM. Simply call 020 7970 4142 or visit www.taxbriefs.co.uk/paf

Winner ISTC UK Technical Communication Award 2013 – Merit Prize for Descriptive Product

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