Danby Bloch: Making the most of tax-free income for clients

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Valuable opportunities have opened up recently for advisers to help clients save tax on their investments. The new elements are the personal savings allowance introduced this year and the nil per cent starting rate band for savings income that came in just over a year ago. Many people will now be able to have up to £17,000 of income tax-free. If they also receive dividends, up to £22,000 of their income could be tax-free as a result of the new £5,000 dividend allowance. But it is important to understand how the rules work.

For these purposes there are essentially three main categories of income: savings income, non savings income and dividends. Savings income consists of interest on deposits in banks and building societies but also includes profits on certain life policies (offshore bonds are most relevant), interest distributions from Oeics and other collectives (but not dividends), income from taxable interest-bearing National Savings and Investments products and the interest element of purchased life annuities.

Non-savings income for these purposes includes pretty much all other income apart from dividends. For most people that essentially means earnings, pension income (private and state) and rent. Then there are dividends, where the tax position has changed a lot from this April.

The different types of income are taxed in a particular order of priority and that order can make a big difference to the amount of income tax payable. The priority order for income tax is earnings and other non-savings income first, then savings income and then dividends.

The starting rate of tax is an odd structure but it can be valuable and important, so bear with it. The maximum 0 per cent starting rate band is £5,000 and is given in full if the individual’s non savings income is less than the personal allowance of £11,000. However, it will not be available at all if the individual’s non-savings income exceeds the personal allowance plus the £5,000 starting rate band – that is, an aggregate of £16,000.

Additional complication

So if the client has a conveniently neat amount of earnings/pension amounting to only £11,000, they could receive their £5,000 of savings income free of income tax. If their non-savings income were £12,000, they could only benefit from £4,000 of the 0 per cent starting rate income band. And if their non-savings income exceeded £16,000, they would get no benefit at all from the 0 per cent starting rate band.

Dividend income does not affect a person’s entitlement to the savings income starting rate band because it sits on top of the savings income and is taxed after it under the priority rules. So our client could have £11,000 of earnings, £5,000 of savings income and thousands of pounds of dividend income but she would still qualify for the nil starting rate band and that would mean her first £5,000 of savings income would continue to be taxed at nil.

That is not all there is to the additional complication of the new savings allowance. For basic rate taxpayers, the allowance means £1,000 of savings income is tax-free. If they happen to slip by a pound into the higher rate band, only £500 of savings income will be tax-free.

In other words, the value of the tax relief is potentially the same whether you are a 20 per cent taxpayer or a 40 per cent taxpayer. But if you have enough income to push you into the 45 per cent tax bracket – even by just a pound – you lose the allowance altogether. From HM Revenue and Customs’ point of view, it will not have to chase up most taxpayers for tiny amounts of tax on deposit interest. Basic rate tax is no longer deducted at source from interest on bank and building society accounts, etc.

It is hard to say how long this will all last. It could be years or it might disappear as quickly as it came. A general point many experts are now making is that clients need to diversify their different sources of income and capital gains into a range of tax wrappers. So where are the planning opportunities?

  1. Some couples might find that one of them has a relatively low level of earnings/pensions and the lower income partner should therefore hold the assets that generate the savings income to qualify for the extra tax-free cashflow.
  2. Non-UK life policies look like attractive ways to generate savings income on either a regular basis or more sporadically.
  3. Business owners living largely on dividend income could consider choosing to take some investment income as savings income.
  4. Children under 18 – and sometimes even older – mostly have relatively low earnings or other non savings income. The tax-free savings income they could receive from a non-UK life policy or other source could be really tax efficient.

The scope to benefit from different tax rules could be especially important for people in retirement. They can then take advantage of the possibility of limiting one kind of income for a few years in order to draw another type of income or gain. In some years, it might make sense to draw relatively little taxable pension, but take a lot of bond withdrawals and capital gains. In other years, it might make sense to maximise the taxable pension benefits. Of course, it is important to make sure the investment strategy drives the tax planning, rather than the other way round.

Danby Bloch is chairman at Helm Godfrey

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Comments

There are 2 comments at the moment, we would love to hear your opinion too.

  1. Indeed, but if I may; there are additions to this ensuring that the only tax you pay is on your pension income (State & Private).

    Not many own OEICS, UTs or ITs in addition to their maximum ISA allowances. If married this is £30,480 per year. ISAs are now transferrable on death between spouses.

    If there is surplus cash what about Insurance bonds? Build up as much as possible and start taking the 5% from (say) age 65. Are you going to worry unduly about a potential tax charge when you are 85? The 5% is on the amount contributed, not the value, so presumably there will be a safety margin built in. At current interest rates 5% looks pretty attractive.

    All this always assumes that the so and so’s don’t renege or change the rules in future.

    • Agreed Harry, we are increasingly using Bonds in this way for clients who are retiring and taking their TFC. 4-5% tax deferred income can be used to supplement or replace un-needed pension income, in the period before any SP kicks in and beyond, especially where they have other investments that can also generate income. This allows the drawdown fund to grow further (and protects the death benefit from potential IHT) or reduces the amount they need to draw, at least initially. The tax on the Bond fund is usually less than 20% and clients have a wide range of fund choices and the option to use segmentation for gifting to family if needed with little or no tax implications for the beneficiaries. A bond also has potential benefit later in life if clients need care, although this is under review at the moment.

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