Maximising your personal tax allowances
Clive Barwell, an Independent Financial Adviser with Wren Sterling, looks at why spotting opportunities to maximise the personal tax allowance and exemptions is so useful for clients.
Most articles extolling the virtues of prudent tax management tend to appear towards the end of the tax year, but why do it all at the last minute?
At Wren Sterling, we see tax planning as a continuous process and always consider the tax implications of what our clients are already doing, or what we recommend they do, at every review.
Using an example scenario, I’ll show how some relatively simple suggestions can ensure the different allowances and exemptions awarded to all of us can work at their most effective.
The key allowances I’ve highlighted are:
- Income Tax – The Personal Allowance
- Capital Gains Tax – The Annual Exemption
- Pension Contributions – The Annual Allowance
- Individual Savings Accounts – The Annual Allowance
- Inheritance Tax – Annual Gift Allowance; Normal Expenditure Out of Income
Income Tax – The Personal Allowance
Everyone, from birth to death, has a personal allowance, which, in 2015/16, is £10,600 (£10,660 for anyone born before 6 April 1938). This means everyone resident in the UK for tax purposes can receive taxable income of up to this limit, without paying any income tax.
For couples (married/civil partnership living together) it means that there can be tax planning opportunities to maximise the use of the personal allowance by altering the way in which assets are held.
To illustrate the point, let’s take the example of a couple – a retired bank manager and his wife who have rental income from a property they own jointly, as follows:
|Mr Smith||Mrs Smith||Joint|
|Tax on the first £31,785 @ 20%||£6,357|
|Tax on the next £8,615 @ 40%||£3,446||£9,803||£0||£13,249|
|Net Income, therefore||£41,197||£8,600||£49,797|
If the property is transferred into the sole name of Mrs Smith, the calculation looks like this:
|Mr Smith||Mrs Smith||Joint|
|Tax on the first £31,785 @ 20%||£6,357||£600|
|Tax on the next £3,615 @ 40%||£1,446||£7,803||£0||£600||£8,403|
|Net Income, therefore||£38,197||£13,000||£51,197|
It is important to note that the property has to be transferred from joint names into the sole name of Mrs Smith; it is not possible just to reallocate the income without changing the ownership. The increase in net spendable income is £1,400 per annum, because Mr and Mrs Smith are now fully using both personal allowances and some of Mr Smith’s income, which is subject to 40% tax, has been reduced and partially replaced with income taxed at 20% in Mrs Smith’s hands.
Whilst we’ve used rental income in this example, the same principal applies with other taxable investment income, such as interest and dividends.
Capital Gains Tax – The Annual Exemption
Everyone, from birth to death, has a capital gains tax (CGT) annual exemption, which, in 2015/16, is £11,100. This means everyone resident in the UK for tax purposes can realise profits on taxable assets up to this limit without paying any CGT.
To look at the way in which CGT works and what the opportunities are for maximising the use of the annual exemption, let’s look at Mr and Mrs Smith again and what happens when they come to sell their investment property. Let’s say that they sell it for £200,000 in January 2016, that they paid £150,000 for it, spent £20,000 on improvements over the years, giving a total acquisition cost of £170,000 and a profit of £30,000.
The property is solely in Mrs Smith’s name, so her tax position at the end of the year will look like this:
|Rent (part year)||£7,000|
So no income tax to pay, as this is fully covered by Mrs Smith’s personal allowance, but we need to know her income as this determines the rate of CGT – 18% on the “top slice” on income up to the higher rate threshold and 28% thereafter.
The taxable gain is:
As this is within the basic rate income tax band (£31,785), it is taxable at 18%, giving a CGT liability of £3,402.
If the property was still in joint names, there would be two annual exemptions available, reducing the taxable gain down from £18,900 to £7,800. As Mr Smith is still a higher rate taxpayer, his half of the gain – £3,900 is chargeable at 28%, whilst Mrs Smith’s is still taxable at 18%, giving a total CGT liability of £1,794, a saving of £1,608.
In a way, this highlights the conundrum of tax planning, as the income tax benefit is with the property in the sole name of Mrs Smith, whereas the CGT benefit is when the property is in joint names. The reality is that most likely the property would be held in Mrs Smith’s name for income tax purposes, but transferred into joint names prior to sale.
It should be noted that the transfer of the property between couples (married/civil partnership living together) is tax neutral from a CGT point of view. A transfer to anyone else would be deemed to be a disposal for CGT purposes.
CGT applies to other investments such as shares and unit trust-type investments not held in an ISA, so the ownership of all such assets should be considered carefully prior to a disposal to ensure tax isn’t unnecessarily paid.
Everyone, from birth to age 75, has a pension contribution annual allowance, which, in 2015/16, is 100% of net relevant earnings (basically salary or self employed earnings), subject to a maximum of £40,000 (or £3,600 without any net relevant earnings). This means everyone resident in the UK for tax purposes can contribute up to £3,600 into a pension, whether they have net relevant earnings or not, or up to 100% of their net relevant earnings.
In the above example, if Mr and Mrs Smith are under the age of 75, one of their options, with the proceeds of their investment property, is to put £3,600 each into a personal pension. This entails a payment of £2,880 with £720 being added by HMRC to the pension.
If Mr Smith was still working and the figure shown for his pension was salary, he could contribute the full £38,600 – a net payment of £30,880 with a top-up from HMRC of £7,720.
Individual Savings Accounts – The Annual Allowance
Everyone, from birth to death, has an individual savings account (ISA) allowance, which, in 2015/16, is £15,240 (£4,080 for under 18s). This means everyone resident in the UK for tax purposes can save or invest via the tax-privileged ISA. Income and any capital gains are tax-free in the hands of the saver/investor.
Again using Mr and Mrs Smith as an example, one of their options with the proceeds of their investment property is to invest £15,240 each into an ISA.
Inheritance Tax – Annual Gift Allowance; Normal Expenditure Out of Income
If we assume that Mrs & Mrs Smith have an inheritance tax (IHT) issue – assets in excess of £650,000 on the second death in 2015/16, then they have two options to help reduce their estates.
Firstly, there is the annual gift allowance, a rather paltry £3,000 each, which hasn’t been increased since IHT was introduced in 1984. With the proceeds of sale of their investment property, they could each give children or grandchildren £3,000 (£6,000 if they didn’t make any gifts last tax year).
Combining allowances we’ve already discussed, this could be a net contribution to a pension for a grandchild of up to £2,880 and/or a contribution to a junior ISA of up to £4,080.
Secondly, if some of their income is demonstrably surplus to requirements and they set-out to make regular gifts out of that surplus income, then such payments are outside of the scope of IHT. Again such payments could be used to fund a pension or ISA, if not needed for such things as school fees or other education costs.
If you are not sure whether you are making the best possible use of your tax allowances and exemptions, talk to your Wren Sterling adviser or contact us to arrange a financial review.
The value of your investment can go down as well as up and is not guaranteed and you may not get back the full amount of your investment.
This information is based on our understanding of current taxation, legislation and HM Revenue & Customs practice, all of which may change without notice. The impact of taxation (and any tax relief) depends on individual circumstances.