Can you cut your income tax bill if you're a high earner?
According to the Office for National Statistics, in the 2021/22 tax year, just over 4.5 million people in the UK were paying higher or additional rate tax, a figure that has risen year on year and will likely continue in this fashion, mainly due to the 5-year freeze on allowances announced in the Budget 2021.
One of the main focuses when advising clients, is creating a plan that helps them achieve their objectives in the most tax efficient manner. There are several ways to reduce the tax you pay on your annual income.
What is higher rate tax
In the UK, we do not get taxed on the first £12,570 we earn from our salary, bonuses, rental income, pensions, and other various income types - this is called our Personal Allowance. Income exceeding the Personal Allowance is then subject to income tax. This is banded so your earnings between £12,570 and £50,270 are taxed at the basic rate of 20%, between £50,270 and £150,000 at the higher rate of 40% and anything above £150,000 is taxed at an additional rate of 45%.
The personal allowance and the higher rate threshold (£50,270) have been frozen until 2026 following an announcement by the Chancellor in the March 2021 Budget.
As inflation continues to soar, exceeding the Bank of England’s 2% target rate, we expect to see the same trend for wages, increasing well above the target rate. Therefore, more people will join the 4.5 million paying 40%-45% tax on their earnings, so it is increasingly important we utilise the tax planning opportunities available to us to minimise the impact of the frozen tax allowances and tax bands.
Up to 60% tax relief available when you invest in a Pension
Investing in your pension pot is an attractive option to increase your savings in a tax efficient way. We actively encourage clients, when suitable, to contribute regular amounts to their pension to not only build up their pension pot but also to benefit from tax efficiencies.
For example, if you wanted to contribute £100 to your pension, it will not cost you £100, in fact, it will cost you £80. This is because you may be eligible for 20% tax relief on your ‘gross’ contribution and HMRC pay the balance of £20 to your plan via your pension provider, so what you will see is the full £100 credited in your pension pot.
When you become a higher or additional rate taxpayer you are eligible to receive tax relief at the higher rate of tax paid i.e. 40% or 45% dependent on your total taxable income. The additional tax relief is normally claimed through your self-assessment tax return.
For some employees, rather than making a personal pension contribution, it can be more advantageous, where the Employer permits, to reduce your take home salary in exchange for your employer contributing more to your pension pot. This is called salary sacrifice which, in addition to the pension contribution income tax relief, creates further savings as lower employee and employer National Savings contributions are payable.
If you have taxable income between £100,000 and £125,140 you can effectively receive income tax relief of 60% on your pension contributions as this is the marginal rate of tax paid on earnings within this band. This is due to the impact of your personal tax allowance of £12,750 being reduced by £1 for every £2 you earn over £100,000 meaning the allowance is reduced to zero when your income reaches £125,140. A pension contribution within this band of earnings effectively reclaims part, or all, of your personal allowance thus increasing the rate of tax relief to 60%.
How to avoid the High Income Child Benefit Charge
An individual can receive Child Benefit if they are responsible for raising a child who is either under 16 or under 20 if they stay in approved education or training. There are two rates in which it is paid; for the first/eldest child, you will receive £21.80 per week and for any additional children, you will receive £14.45 per week per child.
If you are a couple claiming Child Benefit, where one or both individuals have an income above £50,000 per annum, or someone else claims Child Benefit for a child living with you and they contribute at least an equal amount towards the child’s upkeep, you may have to pay a tax charge. This is known as the ‘High Income Child Benefit Charge’. More details can be found on the government website here.
The tax charge is calculated through the tax return on any partner whose income is more than £50,000 a year. In the event that both partners have incomes over £50,000, the charge will apply to the partner with the higher income. The tax charge will be one percent of the amount of Child Benefit received for every £100 of excess income.
One way you may avoid the tax charge is if a personal pension contribution is made, as the adjusted net income used by HMRC will reduce. If the contribution is enough to reduce this to below £50,000, the High Income Child Benefit tax charge will be avoided.
The benefits of charitable giving
Giving to charity is not only good for the cause receiving your donations but is also beneficial to your annual tax bill. If you keep a record of your donations, you will be entitled to report these on your tax return.
The most common way to donate to a UK registered charity or community amateur sport clubs (CASCs) is through Gift Aid. Gift Aid can only be claimed by UK taxpayers and is effectively the repayment of basic rate tax on the donation. This is not repaid to the donor but is given to the charity as they can claim an additional 25p for every £1 they receive.
If you are a higher (40%) or additional rate (45%) taxpayer, you are able to claim the difference between your tax rate and the basic rate of tax (20%) on your total charitable donation. An example of this is shown below:
If you make a charitable gift of £100, the charity will be able to receive £25 from HMRC to reclaim the basic rate tax. As a higher/additional rate taxpayer, you can then claim a further £25 (higher) or £31.25 (additional) relief back via your self-assessment for the £125 (gross) contribution you originally made.
To do this, you must register for gift aid with a ‘Gift Aid Declaration’, keep a record of your gifts and gift no more than four times your total income and capital gains tax payment for the tax year in question. More information can be found here.
Tax relief schemes and other allowances
An investment into a qualifying Venture Capital Trust (VCT), Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS) attracts significant tax benefits. For an EIS or VCT, you can receive 30% income tax relief on the amount you invest, for SEIS this increases to 50% relief. This 30% is only achievable if you have paid sufficient tax for the year in question. For example, if you invested £200,000 into a VCT, you would receive £60,000 tax relief if you had an income tax bill of at least £60,000.
These investments were created by the government, as an initiative designed to help small and medium sized companies raise finance by offering tax benefits to investors. Given the type of companies they invest in, they are perceived to be high-risk investments.
They can be attractive to those who have maximised their other allowances for the tax year and are earning a significant salary which takes them into the higher and additional rate tax band.
These are higher risk investments and not suitable for all investors. There is a chance that all of your capital could be at risk and you should not invest into these types of plans without seeking expert advice from a reputable firm of independent advisers such as The Private Office.
How we can help
There are a number of actions that can be taken to reduce the amount of income tax you pay, which are especially beneficial if you fall into the higher or additional rate tax bands. These tax efficiencies are built into our financial plans, and we actively help clients maximise their allowances and income so they can achieve their goals throughout their lives. If you would like to find out more about how The Private Office can help you with personalised tax efficient financial plans, please enquire for a free initial consultation with one of our Independent Financial Advisers.
Please note: A pension is a long term investment, the value of investments can fall as well as rise. You may not get back what you invest. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation. The Financial Conduct Authority (FCA) does not regulate tax planning or advice.