Talking about incomes has been the order of the day due to austerity measures and changing tax legislation. Those with children are taking a keen interest, not least on how they will be affected by the new child benefit tax charge.
Income is a finely balanced scale where one small tip could lead to a loss of tax-free allowances. Getting the correct measure of income is crucial.
The table below explains the key troublesome income areas. The income limits are based on adjusted net income which is calculated in s58 Income Taxes Act 2007 (ITA 2007).
Step one: Take the amount of the individual’s net income for the tax year.
Step two: Deduct any grossed-up Gift Aid donations (payment x 100/80).
Step three: Deduct any grossed-up pension contributions which were paid net.
Step four: Add back in tax relief received for payments made to trade unions or police organisations which were deducted in arriving at net income in step one.
Net income is an individual’s total income subject to income tax, less specified deductions. The most important specified deductions are trading losses and payments made gross to pension schemes (relief under net pay arrangements).
This is a relatively simple calculation but there are three things to bear in mind to ensure it is as accurate as possible:
1: Capital gains should be ignored.
2: Dividends should be grossed up.
3: The full amount of chargeable-event gains needs to be taken into consideration.
Assessing bond gains for allowance purposes is perhaps not widely known. Many often use the slice of the gain – the total gain divided by the complete number of insurance years the policy has been in force. The slice only has one function and that is in the calculation of top-slicing relief. For all other purposes, the full amount of the bond gain is used.
Bob has children. He earns £30,000 a year but has a £30,000 onshore bond gain earned over five years – a £6,000 slice. There is no further tax to pay on the gain as the slice is within the basic-rate band when added to his other income. However, for allowance purposes, his income is £60,000 which would result in a 100 per cent child benefit charge.
Getting the measure of a client’s income correct is a crucial component of accurately calculating annual tax affairs. Identifying the correct income allows planning to be undertaken to avoid the tax traps.
There are two main ways of reducing adjusted net income.
First, it may be possible to restructure a client’s income. Taxable income could be reshaped into non-taxable income through the use of Isas or bonds. Alternatively, income-producing assets can be passed to lower-earning partners.
Second, making pension contributions or payments to charity under Gift Aid are both simple ways of reducing adjusted net income.
For the planner, knowing a client’s adjusted net income is crucial to ensure they stay the right side of the taxman, and enable appropriate planning to protect their hard earned wealth.
Les Cameron is technical manager at Prudential