Paying too much Income Tax?

By Drew Mitchell

I think it is fair to say we already know the answer to this for the overwhelming majority of people in the country. Of course, we would all like to earn more and pay less tax. For most, the former is in their own hands and destiny, but is there any way to reduce the tax that you pay on the income you work so hard for?

The encouraging news is that the government is working on a number of incentives to try and persuade the British public to increase their own private provisions with a view to the population becoming less dependent on the state in old age. Spearheading these incentives are several different tax breaks relating to individual’s income.

First, a quick reminder of exactly what is included when calculating the tax on your income:

  • money you earn from employment
  • profits you make if you’re self-employed - including from services you sell through websites or apps
  • some state benefits
  • most pensions, including state pensions, company and personal pensions and retirement annuities
  • rental income (unless you’re a live-in landlord and get less than the rent a room limit)
  • benefits you get from your job
  • income from a trust

 

You don’t pay tax on things like:

  • interest on savings under your savings allowance
  • income from tax-exempt accounts, like Individual Savings Accounts (see our article on how to make the best out of your ISA allowance http://cadence-wealth.co.uk/post/personal-allowances-and-isas and National Savings Certificates
  • the first £5,000 of dividends from company shares
  • some state benefits
  • premium bond or National Lottery wins
  • rent you get from a lodger in your house that’s below the rent a room limit

 

Most people in the UK get a Personal Allowance of tax-free income. This is the amount of income you can have before you pay tax. The amount of tax you pay can also be reduced by tax reliefs if you qualify for them. The table below shows the different current income tax bands:

 

Band

Taxable income

Tax rate

Personal Allowance

Up to £11,500

0%

Basic rate

£11,501 to £45,000

20%

Higher rate

£45,001 to £150,000

40%

Additional rate

over £150,000

45%

 

We now go onto consider various popular investments that can help reduce your income tax liability.

 

Pensions

Arguably the most common and effective way of reducing the income tax you pay is by contributing to a pension. With the landscape of pensions in the UK shifting all the time, it is important that you regularly review your own provisions. You can read further information on this on our previous article http://cadence-wealth.co.uk/post/is-70-the-new-65

How much tax relief is available?

Tax relief on contributions is applied at your ‘highest marginal rate’ of income tax. Therefore, basic rate tax payers will get 20% tax relief, higher rate tax payers get 40%, and additional rate tax payers get 45%.
There are limits to the amount of tax relief you can get by making pension contributions. The limit now is the lower of 100% of your earned income or £40,000. The limit may be reduced further if you have already taken an income from your pension, and the rules are also slightly different if a company is making a pension contribution on your behalf. 
The cost for government for Pension tax relief soars into billions of pounds each year and is regularly under scrutiny when the government’s purse strings are tightened so this might be an area that may soon be under serious review.

How does the tax relief work?

If you make a pension contribution out of your own pocket, basic rate tax relief is added to your plan by the pension provider. For example, if you contribute £1,000, the pension provider will reclaim £250 on your behalf from HMRC and £1,250 will be invested.

Higher or additional rate tax payers add the gross contribution to their tax return (£1,250 in this example), and get a tax rebate of £250 for higher rate payers and £312.50 for additional rate payers. It is important to note that you will not receive higher or additional tax relief automatically; it needs to be claimed from HMRC via your self-assessment.

If you are contributing to a company pension scheme, tax relief could be granted in a variety of ways and will depend on how the plan is set up by your employer. This might mean you still having to apply to HMRC to claim your higher or additional rate tax relief.

Reducing income tax is desirable for everyone but those with income of between £50,000 and £60,000 (and receives child benefit) can potentially avoid a tax charge if income is reduced to £50,000. There are similar concerns for those with income of between £100,000 and £122,000 as between these amounts; you lose your personal allowance (this is the amount of income one can earn without paying any tax, currently £11,000).

 

Venture Capital Trusts (VCTs)

VCTs are investment companies that use cash from private investors to invest primarily in smaller companies that operate in certain industries. The government wants to help get the smaller companies off the ground and promote certain industries which in turn will support the government. Some examples of which include green energy to assist with the countries environmental agenda or nursing homes to help with the aging population, so they offer incentives to the private investors to invest into the VCTs. VCTs are run by a fund manager who decides which companies to invest in and given the nature of the underlying companies, VCTs are generally considered only suitable for higher risk investors.

How much tax relief is available?

Unlike pensions, VCT’s offer a tax reduction of 30%, rather than a relief. Investment is limited to £200,000 per annum, giving a maximum reduction of £60,000. For example, for an investment of £30,000 your income tax bill would be reduced by £9,000. The VCT shares have to be held for 5 years, if they are sold sooner, the tax relief is lost. VCT shares are also exempt from Capital Gains Tax (CGT) and any dividends are distributed tax free.

How does the tax relief work?

An investor would inform HMRC, typically by self-assessment, that they have made an investment into a VCT. Using the above example, £9,000 would be deducted from your income tax bill. Importantly, as a tax reduction is awarded against your total income tax liability, relief cannot exceed your total tax liability.

Another example below shows how investing in a VCT for income tax relief might work in the real world:

Charles is a 64-year-old IT sales director, with overall wealth in excess of £3million including property. He earns £295,000 in 2016/17 and wants to reduce his liability to income tax. He applied for fixed protection in 2014, meaning that he can no longer make contributions into his pension.

Ordinarily, he will have to pay a total of £118,850 in income tax on his earnings of £295,000.

No personal allowance

Due to his level of income, his has lost his personal allowance. This means that all his income is taxable; therefore, on the first £32,000 of his income, he will pay basic rate tax at 20% amounting to £6,400. On the next £118,000, he will pay higher rate tax at 40% amounting to £47,200. On the top £145,000, he will pay additional rate tax at 45% amounting to £65,250.

30% upfront tax relief

Charles receives a bonus on top of his salary, most of which is surplus to his requirements. Therefore, he invests £185,000 into a VCT during the 2016/17 tax year. He receives income tax relief at the rate of 30% of his investment. The tax relief therefore reduces his income tax liability by £55,500, from £118,850 to £63,350.

 

Enterprise Investment Scheme (EIS)

Like VCTs, the EIS scheme attracts private investment to small business by offering tax relief to investors. An individual’s Income tax can be reduced by purchasing shares in a company (or companies) that qualify for EIS funding. Alternatively, individuals can invest in EIS funds, which pools cash from other private investors and spreads this across many companies to try and reduce the risk to investor’s capital. Like a VCT, EIS funds are managed by a professional fund manager who decides which companies to invest in.

Whether investment is made directly by purchasing shares of a small company or by investing into an EIS fund, EIS investment is generally considered high risk.

How much tax relief is available?

A tax reduction of 30% is available on investment, up to £1,000,000 per annum, giving a maximum reduction of £300,000. For example, for an investment of £30,000 your income tax bill would be reduced by £9,000. The EIS shares must be held for 3 years, if they are sold sooner, the tax relief is lost.

You will not have to pay any Capital Gains Tax on disposal of EIS shares, providing the shares are held for at least 3 years and you must have received income tax relief on the investment.

There are other tax reliefs and advantages to EIS investment which are beyond the scope of this article as we are primarily focusing on the income tax position of certain investments.

How does the tax relief work?

Usually by self-assessment or by a separate claim made to HMRC. Tax relief will only be applied once you have an EIS3 certificate relating to your investment, which verifies that the investment qualifies as an EIS investment.  It’s worth noting that it can take up to 18 months for these certificates to be issued, so tax relief may not be immediate.  

As with VCTs, investors need a large enough tax bill to absorb the tax relief. If not, you have to forego the excess tax relief.

 

Seed Enterprise Investment Schemes (SEIS)

A more generous counterpart to the EIS scheme, SEIS aims to encourage investment into early stage companies. SEIS is widely regarded as even higher risk that EIS or VCTs and ideally should be set up with the assistance of a trusted accountant.

The tax reduction is higher than EIS investments but the investment usually bears a greater risk.

 

So should I consider VCT’s or EIS’s then?

The tightening of the screw on tax perks and investment limits for pension saving is certainly tempting higher earners to add these riskier venture capital trusts and enterprise investment schemes to their retirement planning.

For those who have already filled their pensions, through the lifetime or annual allowance, can still get a healthy tax relief boost from VCTs. That said, they are not for the uninitiated.

Most people know tax should never be the main motivation for choosing an investment but the generous breaks offered on both VCT and EIS, not least of all the 30% income tax relief, are on paper hard to resist.

However, as with everything there is always a balance to consider, after all, the taxman is not this generous for nothing. The tax carrots are designed to attract money into Britain's riskiest fledgling businesses, which the government says are a vital component of the country's future economic prosperity. With both VCTs and EIS schemes putting investors' cash into high growth entrepreneurial businesses, companies that have fewer than 250 employees, and are either unquoted or listed on the Alternative Investment Market (AIM) there is always going to be a higher risk than investing into the FTSE or S&P.

The main difference between them is that VCTs are more like investment trusts, spreading investors' cash across a number of companies, and are listed on the stock market. An EIS is a direct investment in one company, although it is possible to spread the risk by investing in a fund that holds several schemes. Essentially, those seeking tax-free dividends choose VCTs while growth investors tend to pick EIS. But while the tax breaks are enticing, you need to be happy with the underlying investments.

In summary, the tax breaks are attractive but the risks are high and making a bad or unlucky selection could land you with losses that wipe out the tax benefit, so selection here is the key. As with all other financial planning needs, it is always wise to sit down and discuss the approach with a Financial Professional you trust.

 

 

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