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How the freeze on tax allowances could cost you

“How do we pay for Covid-19?”

A question that sparked much speculation and debate in the lead up to the Spring 2021 Budget - whether we might see a wealth tax for those deemed ‘wealthy’ enough to pay it or a hike in Capital Gains Tax (CGT), we even heard the prospect of limiting tax-free cash from a pension.   

Guessing the Chancellor's next move was hard to call but what few people predicted was that rather than increasing tax during a time of economic fragility, Rishi Sunak would announce plans for a five-year freeze on allowances. A clever move, seen by some, during a politically and economically challenging environment. And whilst the freeze isn’t technically raising tax as wages tend to increase in line with inflation, the reality is that you will end up paying more in tax in the long run, a process called ‘fiscal drag’. Many have argued that this ‘stealth tax’ is simply raising tax by the back door as circa. 1.3 million alone could be brought into the tax system through the personal allowance freezes. 

Here’s how: 

Personal Income Tax Allowance 

How much income tax you pay each year depends on two things, how much of your income is above the personal allowance and how much falls within each band. 

Here’s what your income tax thresholds will look like for each of the next five tax years: 

Income Tax Threshold6 April 2021 – 5 April 2026
Tax free personal allowance – above this charged at 20%£12,570
Higher Rate – above this charged at 40%£50,270
Additional Rate – above this charged at 45%£150,000

Forecasts suggest the Treasury will earn an additional £8 billion in tax compared to the position if thresholds were increased in line with inflation. 

Individuals across the earnings spectrum will be impacted with the Institute for Fiscal Studies suggesting that 1.3 million people who would have previously avoided tax would now be subjected to basic rate tax and 10% of people will be brought into the higher rate bracket at 40%. 

The eventuality of paying more tax as a result of these changes is unavoidable, however it is important to note that these changes will only cause you to pay more tax if your income increases across the thresholds. 

To put this into context, if you currently earn £50,000 a year and are a basic rate taxpayer, but you have received a promotion and your company has decided to increase your salary by £5,000, so you now earn £55,000, you will now be subjected to higher rate tax at 40%. If the higher rate threshold of £50,000 had continued to rise in line with inflation (CPI) at 2.5% over the next 4 years, the higher rate tax on the £55k income would be £4,501 in total up to and including 2025/26 whereas the frozen total is £9,460 so a difference over five tax years of £4,959 additional tax to pay. 

At the other end of the scale if you currently earn £12,000 a year, so therefore you are a non-tax payer, and your wages are increased each year so that in a couple of years' time, you earn £14,000, as the threshold has been frozen, £1,430 of your pay will now be subject to 20% tax, resulting in a tax bill of £286. Whereas if the personal allowance had continued to increase with CPI at 2.5% for example, in 2 years it would have been £13,206 and the extra basic rate tax would be £159.  

So, you can see many of us could be hit with at least some additional tax to pay on our income. 

Pensions Lifetime Allowance

The Pensions Lifetime Allowance (LTA) is a cap on the value of your total pension pots, excluding your state pension, before extra tax charges must be paid.  

The current limit is £1,073,100 and this has been frozen until April 2026. It was due to rise each year in line with inflation, with modest projections placing the LTA at £1.2million by 2025-26. 

The freeze has therefore enforced a ceiling on accruing benefits tax efficiently for the next five years for those affected by the LTA, or likely to be so. To put this into context let's look at an example. Given the projection above a pension fund worth £1.2 million in five years' time will mean £126,900 worth of the pension fund would sit above the frozen LTA and be subject to an LTA tax charge. If that money was taken as a lump sum you would have a tax liability of £69,795 or 55%! 

This makes it particularly important that you understand where your pensions stand today and how they are positioned for the future. Steps can be taken to mitigate any lifetime allowance liability, so it is important to discuss your options now with your financial adviser. 

Inheritance Tax Thresholds

The current nil rate band (NRB) for assets to be passed down free of Inheritance Tax (IHT) has been at £325,000 since 2009/10, so there’s no surprise that it is set to remain there until April 2026 as part of the Chancellors freeze on allowances. The residence nil rate band (RNRB), which only applies to your main residence when passing down to direct descendants (children or grandchildren), was due to increase in line with inflation (CPI), however it will now be frozen at £175,000 until 2026. This is on top of your standard NRB, for those eligible to use the RNRB.

This means that for the next five years a single person can potentially pass on up to £500,000 without an inheritance tax liability whilst a married couple or those in a civil partnership can potentially pass on £1,000,000. However, the freeze outlines two facts, people with an existing IHT liability on their estate will see that liability increase as their estate grows and some individuals will see their estate grow above the frozen thresholds even with modest growth assumptions over the next five years.  

Let’s assume a couple's estate is valued at £1m, if this estate was to grow at a rate of 4% each year for the next five years the estate in 2026 would be worth £1,216,653. Resulting in a taxable estate of £216,653 and an additional IHT tax bill of £86,661. 

It’s important therefore that you know that with the right planning and financial advice there are things you can do today that will help mitigate against the need to pay Inheritance Tax on your estate. From something as simple as spending more money to insuring against the tax liability, your financial adviser can take you through this and other steps that are suitable given your circumstances. 

Capital Gains Tax Allowance

Capital Gains Tax (CGT) is the tax you pay on any profit you make when you sell or dispose of an asset. 

Those who were most concerned about changes to CGT can, for now at least, breathe a sigh of relief as the Chancellor announced that the CGT allowance of £12,300 will remain at its current level for the next five years. There were also suggestions that CGT rates may rise in line with income tax bands which has not come to fruition, as yet. 

Now for the mainstream investor the CGT allowance freeze doesn’t have drastic consequences, as with appropriate planning and timely disposals you will be able to control gains within this limit. 

However, this may be a short-lived sigh of relief.  

With the current UK debt levels, due in the main to the pandemic, standing at around £2 trillion, the big freeze on allowances seems a temporary measure with possibly much more to come. The 2019 Conversative manifesto pledged not to raise income tax, National Insurance or VAT. Whilst the freeze continues to stick to that pledge, the big overhaul of fiscal policy is yet to come. At least for now you can plan ahead for the next five years. 

If you are concerned about your financial circumstances you can get in touch with us and arrange a free consultation today.  

Please note: The Financial Conduct Authority (FCA) does not regulate cash flow planning, estate planning, tax or trust advice.