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23rd April 2021
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income tax

By Sheetal Radia, Chartered Wealth Manager at Ascot Lloyd

With personal allowances set to fall below inflation rises for the first time in over a decade, Ascot Lloyd Independent Financial Adviser, Sheetal Radia, looks at the financial implications for your earnings and the steps you can take to ensure you’re tax efficient.

The March 2021 Budget had to balance supporting the UK economy with finding ways to reduce the debt accumulated during the pandemic. Speculation concerning rises in capital gains tax and pension tax relief have thankfully been set aside for now. However, the Chancellor has managed to have some of his cake and eat it given that inheritance tax thresholds and income tax levels will remain unchanged for the next five years.

Why will frozen tax levels mean I will pay more tax?

By not adjusting the personal allowance and income tax bands in line with inflation, as measured by changes in the Consumer Price Index (CPI), this will mean that as wages rise and the cost of living increases, more people will fall into taxable / higher income tax brackets and end up with less disposable income.

Tax free earning allowance

The personal allowance is the amount you can earn before any income tax is levied. In the tax year 2021/22 this has risen from £12,500 to £12,570 and will remain at this level until the end of the tax year 2025/26. The personal allowance has seen better than inflation rises since the tax year 2010/11 as can be seen in the chart below (chart 1), but income tax levels standing still while wages and inflation increase in real terms mean that you will be worse off.

Why? More people will nudge over the minimum level and will need to start paying income tax while your essential expenditure like groceries will get more expensive, leaving you to make your money go further with less disposable income. For our clients this might mean children or grandchildren, who are just starting their careers, may struggle to make their essential expenses keep up with inflation. The Bank of Mum and Dad may still be a port of call reducing their resources.

Chart 1 Personal Allowance between tax year 2010/11 to 2025/26

Personal Allowance graph

Source HMRC

Average earning income

People who sit in the average income bracket, (based on the ONS data for average regular weekly earnings as of December 2020) of an annual salary of £27,716, will also fall into the stealth tax trap. The first £12,570 of income is tax free due to the personal allowance and the remaining £15,146 will be taxed at 20%. If they don’t receive a pay rise between this tax year and the tax year 2025/26 they will take home the same amount of disposable income, but the cost of living will continue to rise and so be worse of as a result.

Assuming that inflation hits the Bank of England target of 2%, in real terms, the individual with average earnings pays more tax than they would if the personal allowance were to be adjusted in line with inflation. Over a five-year period, this could add up to thousands of pounds, which could make a difference when saving for a first home deposit or just making ends meet.

Higher earners

For an individual on twice average earnings (£1,066 per week or £55,432 per annum) the picture is even more uncomfortable. This is for two reasons:

  1. Firstly, because the personal allowance and basic rate bands together have not changed significantly since the end of 2010/11, the amount which is taxed at 40% will increase as salary increases.
  2. Secondly, income over £50,000 attracts a claw back on any Child Benefit received by them or their partner. As this threshold has not moved either, any increase in income will mean more Child Benefit has to be paid back, so a double whammy!

As you can see in the chart below, the gap between the orange inflation line and the blue actual basic rate band increases over the next 5 years, exposing you to an additional taxable income gap even though the actual tax you pay in the next 5 years will remain unchanged.

Chart 2 – Basic rate band actual (blue bars) vs inflation adjusted (green line)

Actual vs inflation adjusted basic rate band graph

Source HMRC, ONS, Ascot Lloyd calculations

While we cannot change the past, we should be aware of the potential tax implications for the future where allowances and thresholds are not adjusted in line with inflation.

If this individual does not benefit from a pay rise between 2020/21 to 2025/26 tax years, they will pay a cumulative total of circa £4,738 in additional income tax as a result of static allowances and thresholds. The chart below demonstrates how their tax liability increases each tax year as a result of the thresholds not keeping pace with inflation.

Chart 3 – Tax bill rises

Additional tax paid graph

Source HMRC, Ascot Lloyd calculations

The more observant of you will notice that in the tax year 2025/26 the additional tax decreases slightly. This is because the personal allowance and basic rate band when adjusted for inflation are higher than the individual’s gross income. The result is that income above the personal allowance would all fall within the basic rate band and be taxed at 20%. Whereas, under the current environment any gross income above £50,270 will be taxed at 40%.

What can I do to improve my tax efficiency?

The income tax implications are more painful than they first appear for both average and higher earners. Here are a few areas to think about to be more tax efficient…

  1. Mind the gap - It is important to be aware of the impact of inflation on your income, expenditure, cash savings, and investments and look for ways to address any gaps.
  1. Undertake a review of your personal finances and circumstances. Are you making the most of what you have? Are you at least keeping pace with inflation?
  1. Tax efficiency – As a result of the tax take being higher than the headlines suggest, it is important for those that can do so, to explore options available to them, especially the higher earners, which would mean you’re not un-necessarily over-paying income tax.

For example

a. Personal pension contributions can help bring down your taxable income therefore mitigating higher taxes and could also help those that face the High Income Child Benefit Tax Charge. In addition, pension contributions would help take assets outside of your estate, as pension plans are not part of the estate for inheritance tax purposes, so creating additional potential tax savings.

b. Venture Capital Trusts (VCTs) – If the pension contribution route is not viable then investing in these vehicles could be a way of benefiting from tax relief. Of course, these would need to be appropriate for the investor as they are associated with higher risk levels.

c. Enterprise Investment Schemes (EIS) – These schemes also provide tax relief although owing to the nature of the investment these would need to be appropriate for the investor due to the associated risk levels.

d. Company/owner managers – Corporation tax rates for circa 10% of businesses will rise from 19% to 25% in April 2023 therefore employer pension contributions will become even more valuable as they may help to mitigate higher corporation tax rates to come.

The Chancellor’s stealth tax raid in the Spring Budget 2021, means it will go largely unnoticed by the general public, but in real terms the result is a tax increase. This means a large amount of revenue can be raised, while minimising the risk of upsetting the voters. But with the right expert advice there are options to minimise the impact on your finances.

If you have any questions about income tax or your wider financial plan, please do contact your financial adviser or alternatively complete the form below to arrange a call back. We’re here to help.

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Important Information

Investment involves risk.

The information is based on the Company’s understanding of current UK tax legislation and HM Revenue and Customs (“HMRC”).  Levels and bases of taxation and reliefs are subject to change and their value to you will depend on your personal circumstances.

This communication is issued by Capital Professional Limited, trading as Ascot Lloyd. Ground Floor Reading Bridge House, George Street, Reading, England, RG1 8LS. Capital Professional Limited is registered in England and Wales (number 07584487) and is authorised and regulated by the Financial Conduct Authority (FRN: 578614).

This communication/presentation is for information purposes only. Nothing in this communication constitutes financial, professional or investment advice or a personal recommendation. This communication should not be construed as a solicitation or an offer to buy or sell any securities or related financial instruments in any jurisdiction. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the document. Any opinions expressed in this document are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or companies within the same group as Ascot Lloyd as a result of using different assumptions and criteria.