The last few weeks of the tax year are key weeks in which to consider tax planning to maximise the use of an individual’s allowances, reliefs, exemptions, etc for the current tax year. Some of these will be lost if not used before the tax year end.
In the run-up to the Budget and the new tax year end, taxpayers should at least consider possible action to optimise their tax position.
As well as last-minute tax planning for 2010/11, now is also a good time to put in place strategies to minimise tax in 2011/12.
This year, effective planning will be more important than ever for those on higher incomes because of the direct and indirect increase in tax rates which took effect from April 6, 2010.
Tax planning is an important part of financial planning but it is not the only part. It is essential that any tax planning strategy being considered also makes commercial sense.
In this article, all references to married couples include registered civil partners.
1: INCOME TAX
Four key tax rules apply for tax year 2010/11:
the basic personal allowance is £6,475; this is due to increase to £7,475 in 2011/12;
the basic rate limit remains at £37,400; this is due to reduce to £35,000 in 2011/12;
a 50 per cent tax charge applies to taxable income that exceeds £150,000;
people with income of more than £100,000 may find that they will lose some or all of their basic personal allowance.
The impact of (i) and (ii) means that even more people have fallen into charge to higher-rate tax and the impact of (iii) and (iv) means that people with incomes of more than £150,000 and £100,000 respectively will pay even more tax.
Although there will be an increase of £1,000 in the basic personal allowance for 2011/12 to £7,475, the benefit of this change will be counterbalanced for higher-rate taxpayers by a reduction in the basic-rate limit to £35,000. In turn, in 2011/12, this would make the starting point for higher-rate tax £42,475 against the current £43,875.
From the above, three categories of people can be identified who have been particularly disadvantaged by the income tax changes that have taken place and will take place:
(i) Those with taxable income of more than £150,000 who suffer 50 per cent income tax (42.5 per cent on dividend income). For such people, who are married, the tax savings available by diverting income into the lower-income spouse’s name will be even more substantial.
(ii) Those with income of more than £100,000 who lose all or part of their basic personal allowance and so suffer an effective tax rate of up to 60 per cent on the “offending income”. For such people, the diversion of income as in (i) above would mean that income in the band from £100,000 to £112,950 could suffer tax at 40 per cent rather than 60 per cent. Where it is earned income that takes the individual into the £100,000 – £112,950 income bracket they should seek to reduce this by either; paying a pension contribution; or, arranging for an indirect pension contribution via a salary sacrifice.
(iii) Those who will drop into higher- rate tax for the first time because of the freezing of the personal allowances and higher- rate tax threshold in 2010/11. Even more face the prospect of being affected by these changes in 2011/12.
Set against this background, the following tax planning possibilities exist for most people regardless of their tax position.
For married couples, who carry out appropriate planning, there are possibilities to save income tax. Most of these need a full tax year to operate to give maximum effect so these suggestions may serve more as a reminder for planning for the coming tax year than as a means of saving tax this year.
Where a higher/additional-rate taxpaying spouse owns investments, income from these may suffer tax at a rate of up to 40/50 per cent or 32.5/42.5 per cent (if dividends). Therefore, subject to practical considerations, the transfer of investments to a lower or non-taxpaying spouse can save tax and increase overall investment returns. Such transfers must be outright and unconditional.
Where possible, a couple should try to ensure that they both have pension plans to provide an income stream in retirement that will also use their personal allowances.
Clients should make maximum use of all personal allowances available to them and their family. A husband and wife each have their own personal allowance. This is particularly relevant where one spouse pays tax at a lower rate than the other. A non-working spouse with no investment income will be able to receive income of £6,475 for tax year 2010/11 (£7,475 for tax year 2011/12) before he or she pays any tax.
Older married couples benefit from an increased age-related personal allowance. This is cut back if their income exceeds the age allowance limit. It may be advisable to transfer income-producing assets between couples where one would otherwise exceed the age allowance limit of £22,900 for tax year 2010/11 (£24,000 for tax year 2011/12).
Business owners may consider the payment of a salary to a lower or non-taxpaying spouse can be made (provided, of course, he or she performs work for the business that fully justifies the payment). This could be up to the NIC free limit (currently £110 a week, rising to £136 a week in 2011/12 if both employers’ and employees’ NICs are to be avoided) that would still attract contributory state benefits and give the ability to pay additional pension contributions.
With the rates of tax effectively having increased, it is most important that people invest in the most tax-efficient way possible.
The Isa is still the main method of investing savings with freedom from income tax and capital gains tax without giving up the flexibility of access to the investments.
For this tax year, the overall annual contribution limit is £10,200, of which no more than £5,100 can go into cash. The balance can be invested in a stocks and shares Isa. This means a couple could between them invest £20,400. For tax year 2011/12, the overall annual contribution limit per individual rises to £10,680. A child aged 16 or over can invest £5,100 in a cash Isa in this tax year, £5,340 in 2011/12.
Investors who are 50 per cent taxpayers are more likely to be using their annual CGT exemption on a regular basis and so, for them, an investment in an Isa is almost essential.
(ii) Growth-oriented unit trusts/Oeics
Given the relatively high rates of income tax as compared with the current rates of capital gains tax, subject to investment considerations, it makes tax sense to invest for capital growth as opposed to income.
Although income (dividends and interest) on collectives is taxable – even if accumulated – if this can be limited then so can any tax charge on the investment. Instead, if emphasis is put on investing for capital growth, not only will there be no tax on gains accrued or realised by the fund managers, it should also be possible to make use of the investor’s annual CGT exemption (currently £10,100) on later encashment.
Gains in excess of the annual exemption only suffer CGT at 18 per cent and/or 28 per cent currently (depending on the investor’s income tax position). For couples, it makes sense for them both to invest in order to be able to use both annual CGT exemptions when investments are encashed.
Single-premium investment bonds
Because single-premium investment bonds are non-income-producing, no taxable income arises for the investor during the accumulation period.
Not only that, any dividend income accumulates without corporation tax within a UK insurance company’s internal investment funds.
However, bonds are not so tax-efficient from a CGT standpoint with capital gains (after indexation allowance) realised by the UK life fund suffering corporation tax at an effective rate of up to 20 per cent. The investor policyholder will receive a basic-rate tax credit for taxation in the fund, meaning that, on eventual encashment, a tax charge will only arise if the investor (after top-slicing relief) is then a higher-rate or additional-rate taxpayer.
More tax efficiency at fund level can be achieved via an offshore bond because there is no internal tax charge on investment growth. However, there is then no tax credit for a UK-resident investor. Whether a UK or offshore bond is best for any particular investor will depend on the facts.
(iv) Maximum investment plans
The Mip, which is enjoying a new lease of life as a result of the restrictions on pension tax relief, has become even more attractive for high- earners willing to make long-term regular savings. Within a UK life company (which is the “compulsory” wrapper), Mip funds are subject to a maximum of 20 per cent tax on income and post-inflation capital gains.
The main tax attraction of these plans is that the proceeds at maturity (usually after 10 years) are generally completely tax-free, irrespective of amount.
It may also be possible to take benefits as regular tax-free payments. The plans can be written under a reverter to settlor trust so that the benefits payable on death within the first 10 years are free of inheritance tax yet the settlor can benefit at maturity of the plan.
(v) Enterprise investment schemes
The EIS offers tax relief on an investment in new shares of an unquoted trading company which satisfies certain conditions.
For tax year 2010/11, an investment of up to £500,000 can be made to secure income tax relief at up to 20 per cent with relief being restricted to the amount of income tax otherwise payable.
Unlimited capital gains tax deferral relief is also available on an investment in an EIS provided some of the EIS investment potentially qualifies for income tax relief.
The EIS capital gains tax deferral relief is now more valuable, given the increased rate of CGT.
However, the three-year timeframe for earlier gains needs to be treated with caution – there is little point in deferring gains taxable at 18 per cent if they subsequently suffer tax at 28 per cent.
(vi) Venture capital trusts
The VCT offers income tax relief for tax year 2010/11 at up to 30 per cent for an investment of up to £200,000 in new shares, with relief being restricted to the amount of income tax otherwise payable. Dividends and capital gains generated on amounts invested within the annual subscription limit are tax free.
2: NATIONAL INSURANCE CONTRIBUTIONS
An increase in NICs for employees and employers will take effect from April 6, 2011. These NIC rates will each go up by one percen- tage point to 12 per cent (employee) and 13.8 (employer). Employees will also pay a 2 per cent surcharge on earnings above the upper earnings limit.
For those employees who will be affected by this increased NICs’ burden, salary sacrifice pension arrangements remain attractive. These enable the employee to sacrifice salary (and so save NICs) and in return, the employer will make a pension contribution of the sacrificed salary plus some or all of the saved NICs.
The end of the tax year is the time when individuals consider how best to maximise their pension contributions. When advising on how best to maximise pension contributions in 2010/11, account needs to be taken of:
- The special annual allowance, for those individuals with relevant income of £130,000 or more in 2010/11 or either of the previous two tax years;
- The annual allowance in 2010/11 and beyond;
- The relievability of personal and, where appropriate, employer pension contributions;
- The pension input period of the scheme(s) to which contributions are being paid;
- The lifetime allowance, and its reduction to £1.5m from 2012/13; and
- The NIC increases from 2011/12, which favour arranging salary/bonus sacrifice after April 5.
An individual, who is sub-ject to the special annual allowance, will be restricted in the maximum contribu-tions that can be paid by and on his behalf without suffering an annual allowance tax charge up to the greater of:
- the special annual allowance (normally £20,000 but potentially up to a maximum of £30,000 where sufficient “infrequent money-purchase contributions” have been paid in tax years 2006/07, 2007/08 and 2008/09), and
- Their protected pension input that is, essentially regular contributions at a frequency of at least quarterly that were already in place prior to April 22, 2009/December 9, 2009, as appropriate, and/or pension input as a member of a defined-benefit pension scheme of which he was a member prior to April 22, 2009/December 9, 2009, as appropriate).
The special annual allowance rules cease on April 5, 2011. This means that where an individual’s contributions have been constrained by the special annual allowance in either or both of tax years 2009/10 and 2010/11, he may be able to take advantage of the new carry forward of annual allowance provisions in 2011/12.
However, great care should be taken where the intention is to pay contributions before the end of this tax year, even if the scheme into which they are being paid has a pension input period ending in tax year 2011/12.
Although such contributions would be set against the annual allowance in 2011/12, they will still be assessed against the special annual allowance in the current tax year.
This is because the special annual allowance takes account of all contributions/ increased benefit accrual in the tax year concerned (that is, the actual pension input period is irrelevant).
Therefore, any contributions in excess of the special annual allowance limits should normally be paid no earlier than April 6, 2011.
In theory, any individual who is not subject to the special annual allowance in 2010/11 is able to make aggregate pension savings of up to £255,000 in pension input periods ending in tax year 2010/11.
In practice the pension savings that can be made will be dependent upon:
- Whether an individual is employed or self-employed. If self-employed, any tax- relievable pension contributions will be limited to 100 per cent of the relevant UK earnings, which, by definition, will need to be less than £255,000 as 2010/11 relevant income must be less than £130,000 to sidestep the special annual allow- ance regime.If the individual is employed, it would be possible for the employer to pay a contribution of up to £255,000, although relief will only be available on an employer contribution where it is paid “wholly and exclusively for the purposes of the trade”.
- In any event, the employer would need sufficient profits (potentially accessed by carry back of losses) to relieve the contribution.
- The ability to ensure that any pension savings are made to pension input periods ending in 2010/11.
- The extent to which any pension savings are likely to result in the individual’s lifetime allowance being exceeded, especially as the standard lifetime allowance falls to £1.5m from 2012/13. If an individual is likely to be affected by this reduction, account would also need to be taken of a possible election for fixed protection.
- The changes being made to the age 75 rules and, in particular, the introduction of the new drawdown rules from April 6 this year may also trigger a need for pension planning before the tax year end.
If an individual is looking to start income withdrawals soon, or is already in drawdown, and wants to maximise their income (or minimise the amount crystallised for a given income) they may be able to lock in a higher limit for up to five years by acting before April 6, 2011.
From 2011/12, unsecured pension will be renamed drawdown (capped or flexible). Under the new drawdown rules, the maximum income will be:
- based on 100 per cent rather than 120 per cent of the relevant annuity rate obtained using the HM Revenue & Customs/ Government Actuary’s Department tables and
- based on revised HMRC/GAD rates, which will be lower than those currently in use.
The new rates do not, however, become effective for existing members taking withdrawals from an unsecured pension prior to April 6, 2011 until the fifth anniversary of the last review date undertaken before April 6, 2011.
This means that:
- A member could bring forward the date he wishes to commence income withdrawals to before April 6, 2011 to lock in the higher income.
- A member already in drawdown with an anniversary of a five-year review date before April 6, 2011 could elect, prior to that anniversary date, to initiate a new five-year review period from that anniversary date, locking in the higher income for up to five years.
Before making any such decision, a client will need advice on the implications of the change. For example, will the attraction of the potential higher draw- down limit outweigh the advantage of keeping the maximum amount of fund uncrystallised for death benefit reasons (for example, by means of phased drawdown)?
4: CAPITAL GAINS TAX
The main planning points are:
- The annual exemption for 2010/11 is £10,100. For higher and additional-rate taxpayers the exemption could save £2,828 tax (at 28 per cent) and for others £1,818 (at 18 per cent). The annual exemption cannot be carried forward.
- The annual exemption is available to each of a married couple so, between them, gains of up to £20,200 can be realised without any CGT liability. Transfers between spouses could effectively double the potential use of the annual exemption.
- Now that the rate of CGT (18 per cent and/or 28 per cent) is determined by reference to the rate of income tax a person suffers (20 per cent and/or 40/50 per cent), logic dictates that taxable gains should be realised by the lower (basic or less) taxed spouse where possible. Even if both spouses are taxed at the same rate, there may still be an opportunity to use two annual exemptions rather than one (see above) and limit the scope for a part of any gain to be pushed into the 28 per cent band.
- Gains arising in 2010/11, but before June 23, 2010, are liable to tax at 18 per cent, and will not be taken into account in determining the rate (or rates) at which gains arising on or after June 23, 2010 should be charged.
- To ensure gains are properly realised the disposer must not personally reacquire the same investment within 30 days of disposal. However, there ways of achieving a similar result; for example by Bed-and-Isa and Bed-and-Sipp.
5. INHERITANCE TAX
We now know that the inheritance tax nil-rate band will be frozen at £325,000 until April 6, 2015. The freezing of the nil-rate band is clearly bad news for some wealthier clients who have a potential IHT liability on their death but cannot afford to gift capital. For them, insurance-based trust solutions in the shape of discretionary trusts, loan trusts and discounted gift trusts may well be suitable.
All those who are concerned about inheritance tax should at least seek to use their available £3,000 annual exemption(s) before the end of the tax year. For those with surplus income regular gifts of income can use the normal expenditure out of income exemption.