With interest rates at such low levels it has never been more important to understand how to boost clients’ income. One of the easiest ways is to make sure you are taking advantage of the tax allowances available.
In April last year, then-chancellor George Osborne introduced significant changes to the tax regime, including the nil-rate starting band for savings income. The Treasury followed this up this year with the introduction of two new allowances:
- Personal savings allowance
- Dividend allowance
It is fair to say there was originally some confusion around how the allowances worked and interacted with the different tax bands. It was also considered the changes were created to benefit those on lower levels of income; however, people with a taxable income greater than £16,000 can take advantage.
The 2015 change
The nil-rate starting band is available for those with non-savings income such as earned income or pension income if it is below the personal allowance (£11,000 in 2016/17). This means some individuals have a £5,000 nil-rate band for savings and £11,000 personal allowance this tax year. So a total of £16,000 is under the nil-rate band for savings.
For instance, say your client’s pension income is £10,000 a year and they receive a further £3,000 per year in interest from building society savings, then they are entitled to receive the pension income free of tax because it is within the personal allowance and savings income is within the nil-rate band for savings and charged at a zero rate of tax.
Added level of complexity
So far so good but things got a little bit more complicated this year with the introduction of the two new allowances.
The personal savings allowance is set at £1,000 for basic rate taxpayers and £500 for higher rate tax payers. Additional rate taxpayers have no entitlement. So if, for example, you have an employment income of £14,000 and receive interest on bank savings of £3,000 each year, then you are entitled to zero rate tax on £2,000 of your savings income. The remaining £1,000 would be assessable to basic rate tax.
The way dividends were taxed also changed. Dividend payments were received with a deemed tax credit which fulfilled the obligation for a basic rate taxpayer and the first part of the liability for higher and additional rate taxpayers. This year’s changes removed the deemed tax credit and introduced a dividend allowance of £5,000, which is available to everyone.
The new rule essentially means the first £5,000 of dividend income is not liable to tax. Any dividend income after that is liable to tax at an ordinary rate of 7.5 per cent, an upper rate of 32.5 per cent or the additional rate of 38.1 per cent, depending on which tax bracket it falls.
So, for instance, if your client has £40,000 of earned income and £7,000 in dividend income, the first £3,000 of the dividend income falls into the basic rate and the next £4,000 is under the higher rate. However, of this, the first £5,000 has no tax liability. So the remaining £2,000 is liable to tax at the dividend upper rate of 32.5 per cent.
Making the most of it
The key to making the most of a new tax regime is understanding the order of taxation. In terms of income there are four main categories taxed in the following order: earned income, interest and savings, dividends and life policy gains.
For example, if someone is paid £14,000, has a dividend income of £4,000 and a savings income of £4,000, they have a total taxable income of £22,000, surpassing the £16,000 limit.
However, because their earned income is only £14,000, the first £2,000 of the savings income is still eligible under the starting rate band. So they will not pay tax on that. There is also the £5,000 dividend allowance, which means there is no tax liability on the dividend income.
The order of taxation also means investing in an offshore life assurance or redemption policy can lead to substantial savings. The taxation of offshore policy falls within the savings income bracket unlike onshore policies, which are always taxed at the highest marginal rate of tax, because the assets within the policy are deemed to be taxed at basic rate which is non-reclaimable.
The Government has introduced several changes over the past two years. With change comes opportunity and the need to reassess clients’ needs and objectives. Understanding and applying the new rules can lead to significant tax savings. With generating income becoming increasingly difficult, it has never been more important to make sure it is in the most tax efficient way.
Gordon Andrews is tax and financial planning expert at Old Mutual Wealth