Your tax allowances and how to use them

In his November 2022 Autumn Statement, Chancellor of the Exchequer Jeremy Hunt froze some tax allowances and reduced several others. These effective tax increases affected many ordinary taxpayers, meaning more of us are having to complete tax returns.

The increases also suggested more of us could potentially benefit from appropriate financial advice. For example, people with actively managed investment portfolios are more likely to incur capital gains tax (CGT) as a result of portfolio changes, and could potentially benefit from help with how to manage these portfolios tax-efficiently.

In this article, we outline the tax regime as it stands today, what it means in broad financial planning terms and how you could potentially benefit from the remaining tax incentives. But it’s worth bearing in mind tax planning varies with the circumstances of each individual and tax laws may change in the future.

First, the annual income threshold for the 45 per cent additional rate of income tax now stands at £125,140. As our Pensions and your personal allowance article shows, people earning between £100,000 and £125,140 are already, in effect, paying a 60 per cent income tax rate. This is because, for every £2 of salary above £100,000, the personal allowance is reduced by £1.

Frozen tax thresholds

Second, HMRC is set to maintain the income tax personal allowance, higher rate threshold and main national insurance thresholds until April 2028. But these currently static tax bands mean that, as people’s earnings increase, more of us will fall into higher tax brackets. Once again, this can reduce our real disposable income.

Third, the share dividend tax-free allowance was cut from £2,000 to £1,000 in April 2023 and will be further cut to £500 from April 2024.

Finally, the capital gains tax (CGT) allowance was cut from £12,300 to £6,000 in April 2023 and will be cut further, to £3,000, in April 2024. CGT is a tax on the profit (the ‘capital gain’) made from an asset that has increased in value, typically when the asset is sold. It applies to items including: property that is not a main home; investments not held in tax-efficient schemes such as ISAs (Individual Savings Accounts) or pensions; and business assets.

CGT rates and rules are complex. For example, CGT rates differ for basic rate and higher rate taxpayers, and they differ between property and non-property assets. And sellers of a business may be able to benefit from ‘business assets disposal relief’. Our article on capital gains tax has more information.

Reduced allowances means financial planning could become even more important for many of us. Ensuring we’re using a suitable blend of different tax wrappers, such as pensions, ISAs, dividend allowance, VCTs (venture capital trusts), and onshore and offshore bonds where appropriate, could be even more crucial when tax allowances are limited.

Personal savings allowance

Some tax allowances are often overlooked. The personal savings allowance, for example, lets you earn interest tax-free on your savings, with the annual tax-free limit dependent on your income tax rate, as follows:

Additional rate (45 per cent) taxpayers are not given a personal savings allowance.

Premium bonds

Premium bonds also offer tax benefits, as the prizes are tax-free (1). In November 2023, the annual prize rate was 4.65 per cent. But the odds of winning a premium bond prize are just 21,000 to one (for every £1 bond). So you would need to hold a significant amount of them to have a good chance of reaching the annual prize rate. You can each hold up to £50,000 in premium bonds.

Gifting

You can also gift up to £3,000 each year tax free. Gifts to your spouse are usually tax free with no limit. Not only could your gift help others, but it would also no longer be included in the value of your estate, and so wouldn’t be liable for inheritance tax.

Pensions

Crucially, pensions allowances were increased in March 2023. This means people who have not used up their pensions allowance may be able to reduce tax liabilities by transferring more of their income to their pension. Putting more into a pension may not be the right thing for everyone. Even so, it is something many of us may want to consider.

The way to make the most of the pension tax allowance is, quite simply, to pay more into a pension. Rules on pensions are fairly straightforward if your payments are well within HMRC’s contribution limits. But they can be quite complex if you’re close to or exceeding those limits, and only brief details are given in this article.

You get tax relief on your pension contributions at the rate you pay income tax. And any pension fund growth is free of tax. Personal pensions are topped up by the government. For every £800 someone pays into a personal pension, the government adds £200 basic rate tax relief; higher rate taxpayers get a further £200 of tax relief through their tax assessment.

The retirement benefits you receive from your pension plan depend on several factors, including the value of your plan when you decide to take your benefits. The plan isn’t guaranteed and can go down as well as up. In fact, the benefits of your plan could even fall below the total amounts paid in.

Pension contribution limits

For most of us, the amount we can contribute tax-efficiently into a pension is capped at a maximum £60,000 per year (this includes any contributions from our employer). But the amount we can contribute is linked to what we earn. If we earn more than £60,000 a year, then we can usually put in up to the maximum amount. People who have no earnings can generally put just £3,600 a year into a pension. But, due to pensions tax rules, non-earners only need to contribute £2,880 and HMRC will then add £720 of basic rate tax relief to bring the total contributions to £3,600.

High earners should be mindful that, once they earn more than £200,000 a year, the amount they can then pay into a pension tax-efficiently could reduce. Our article on tapered pension allowance for high earners provides more information on this.

There is currently no limit to the total amount you can invest tax-efficiently in a pension throughout your lifetime.

Maximising pension allowances involves making sure you know what your available allowances are and what your unused allowances are. If you have the capacity to invest the maximum annual allowance, then there may be benefits in doing so.

Pension carry forward

People who want to invest more than £60,000 in a pension in a tax year may be able to do so through pension carry forward. This is an allowance enabling you to utilise unused pension allowances from previous tax years. It can be useful if you’ve used up all of your annual pensions allowance for the current tax year. This is because it can enable you to make tax-efficient pension contributions that exceed the current tax year’s pensions allowance.

Let’s suppose you’ve made a maximum allowable pension contribution from your earnings (including any employer contributions) of £60,000 in the current tax year. Then any earnings in excess of your pension contributions could potentially be subject to income tax. But unused pensions allowances from the previous three years aren’t necessarily lost, as you can bring these forward into the current tax year.

So, if you had a total of £40,000 of unused pensions allowances from the previous three years, then you could add this figure to the £60,000 pensions allowance from the current tax year. You would then have a pensions allowance in the current tax year of £100,000. But you would need to be earning at least £100,000 in the current tax year to use all these allowances. That’s because your current year’s salary sets the limit for how much can be used from all four years.

But what if you have exceeded your annual pension allowance and you’ve used up all your carry forward? In this case, your first port of call for tax-efficient investing could be ISAs. A key benefit of pensions is that the money you initially invest in a pension can be free of tax. On the flipside, when you come to draw on your pension, that income may then be subject to tax (over and above taking 25 per cent of the pension pot value as a tax-free lump sum up to a limit of £263,275).

Stocks and shares ISAs

With ISAs it’s the other way around. In other words, you may already have paid taxes on the money you invest in an ISA, but you are not liable for tax on income or capital gains arising from your ISA investments if and when you come to encash them.

In this article we just consider stocks and shares ISAs, which are free of capital gains tax and income tax. Stocks and shares ISAs can contain company shares, corporate bonds, government bonds, and investment funds and unit trusts. If you’re aged 18 and above, you can invest up to £20,000 annually in a stocks and shares ISA (minus any amount you’ve paid into a cash ISA in that same tax year). And the ISA does not terminate when the tax year ends, but stays active for as long as the ISA remains invested.

AIM portfolios

Moreover, ISAs can hold AIM (Alternative Investment Market) share portfolios. AIM is a London stock market for shares in small and medium-sized companies. Once an AIM portfolio is held for two years, it is effectively free of inheritance tax (technically, the portfolio value is subject to inheritance tax, but at a current rate of 0 per cent). This means these portfolios could be passed on to loved ones with no inheritance tax liability. But AIM companies are subject to lighter regulation than companies listed on the main stock market and they are generally higher risk investments.

General investment accounts

Clients who have used up both their pensions and their ISA allowances, could consider general investment accounts (GIAs) and onshore or offshore bonds. But whether and how many of these are used depends on personal circumstances.

GIAs are investment accounts held outside a pension or ISA. They are subject to tax, so you can be liable for CGT on any capital gains made above your CGT allowances. You could also be liable for income tax on any income received and for higher or additional tax on dividend payouts above your dividend allowances. Even so, GIAs can be a good way to make use of these allowances.

Crucially, the CGT rate on GIAs for basic rate taxpayers is 10 per cent, significantly lower than the 20 per cent rate for higher rate tax payers. Similarly, the dividend tax rate is just 8.75 per cent at the basic rate, but a significantly higher 33.75 per cent at the higher rate and 39.35 per cent at the additional rate. Consequently, GIAs can be more suited to basic rate taxpayers who can benefit from these lower tax rates.

Onshore and offshore bonds

In contrast, higher and additional rate taxpayers could benefit from investing in offshore or onshore bonds. These bonds can hold a wide range of assets, including shares (equities), bonds and property. They are not subject to CGT but are subject to income tax. Even so, you can withdraw 5 per cent of the original capital each year without facing any immediate tax charges. This arrangement of tax deferral is cumulative, so if you don’t withdraw the annual 5 per cent, then it will build up, enabling you to withdraw more than 5 per cent later on. In addition, these bonds can be particularly tax efficient if encashed at a future date by someone such as a family member who is a nil or lower rate taxpayer. And they can play a useful role in estate and inheritance tax planning.

Venture capital trusts

If you’ve fully used up your pensions allowances, ISA allowances and other tax allowances and you have a tax bill, then venture capital trusts (VCTs) might be a suitable option. VCTs are listed on the stock exchange with a remit to invest in small, unquoted, higher risk companies.

VCTs offer 30 per cent tax relief for investors who subscribe for new shares prior to the VCT listing, as long as the VCT is held for five years. So a £20,000 investment in a VCT could reduce your income tax bill by £6,000. Indeed a VCT investment can sometimes wipe out an entire income tax bill. Moreover, VCTs are not liable for income tax on dividends or for CGT.

VCTs are higher risk investments, reflecting the higher risk nature of the companies they hold. But they invest in a range of companies, so investors could benefit from a degree of diversification.

VCTs have the potential to offer financial planning benefits to clients who are willing to accept the higher risks and who have the financial capacity to withstand potential investment losses.

Enterprise investment scheme

Enterprise investment scheme (EIS) investments also offer 30 per cent tax relief upon subscription and are considered even higher risk than VCTs, but they do come with even greater tax incentives. For example, by investing in an EIS you could potentially defer CGT liabilities incurred from selling other investments or a second home. Moreover, unlike VCTs, EISs can be free of inheritance tax, as long as they are held for at least two years.

VCT investments are limited to a total of £200,000, but you can generally invest up to £1 million in an EIS. But EISs are not listed on the main stock market (although some are quoted on London’s AIM market) and so can be harder to sell. Their limited tradability, coupled with their high-risk characteristics, make EISs inappropriate for many investors.

Spouse’s allowances

Finally, if investment returns are eroded by tax then you could consider using your spouse’s allowances. If your spouse isn’t earning an income and you use their allowances, then you could potentially reduce your overall tax payments.

Moreover, couples can try to maximise their combined allowances by taking advantage of any differences in their individual tax bands when setting up investments. But, as is the case with financial planning in general, this can be complex and you may want to seek the advice of a good financial adviser.

Sources:

(1) www.nsandi.com, ‘Premium Bonds’, November 2023.