Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Tax-saving tips for higher earners
The Government has cracked down on tax avoidance schemes but there are still plenty of legitimate ways for higher earners to reduce their tax bill.
The more tax wrappers and annual allowances you use, the more money you’ll be able to save and invest for your future.
Maximise your ISA allowance
Under current rules you can invest £20,000 each year into ISAs, which shield your money from income tax and capital gains tax (CGT). This represents a significant tax saving for higher earners.
Large investments held outside an ISA wrapper can often become liable to CGT, which is levied at 20% on higher earners.
If you earn dividend income above £5,000 outside an ISA, the tax levied on higher earners is 32.5%, rising to 38.1% for additional rate taxpayers. The tax-free dividend income threshold is dropping from £5,000 to just £2,000 from April 2018.
ISAs have many other advantages. ‘ISAs do not require the same commitment that other tax savings products do,’ says James Mullarkey, report writer at financial advice firm Ascot Lloyd. ‘Capital from ISAs can be withdrawn at any time which gives investors more flexibility, but it also means that they suit more liquid assets.’
Most people can pay up to £40,000 into pensions each tax year. But since 6 April 2016, the annual allowance has been tapered for people with more than £150,000 of annual gross adjusted income and a threshold income of more than £110,000 in the same tax year, falling by £1 for every £2 of income between £150,000 and £210,000. This means some people have an annual allowance of just £10,000.
It’s still worth contributing to your retirement savings pot. For every £1,000 that ends up in your pension, higher rate taxpayers get £400 of tax relief from the Government and additional rate taxpayers get £450.
Charles Calkin, a financial planner at James Hambro & Co, says if you can use salary sacrifice the benefits are even greater.
Salary sacrifice involves giving up part of your salary and, in return, your employer gives you a non-cash benefit such as childcare vouchers or increased pension contributions.
Once you accept a salary sacrifice, your overall pay is lower and so you pay less tax and National Insurance. Your employer will not have to pay their Employers’ National Insurance contributions on the part you sacrifice – which has led to some employers passing on some or all of these savings to you.
Use carry forward
If you’re restricted to contributing only £10,000 to your pension, you may be able to take advantage of unused allowances from the previous three tax years.
This could allow you to make contributions of up to £130,000. But Calkin says there are complexities.
‘You need to have earned in this year all the money you are investing, you have to have had a pension in place for all the years you are carrying forward and you need to be careful that you are not breaching or threatening to breach the lifetime allowance, which is now down to £1m,’ he explains.
Try to avoid one partner being the sole owner of your savings because this prevents you taking advantage of all your allowances.
Each spouse has a CGT allowance of £11,300, a personal income allowance of £11,500 and a £5,000 dividend allowance (reducing to £2,000 from April 2018).
You can also earn up to £1,000 in income from selling goods or providing services and a further £1,000 allowance on income from owned property.
Spousal transfers are CGT free, which may prove useful if one partner pays a lower rate of tax than the other.
Invest in VCTs and EIS
Venture capital trusts (VCTs) and Enterprise Investment Scheme (EIS) funds offer generous tax breaks.
VCTs provide 30% income tax relief on annual contributions of up to £200,000, as long as you hold the VCT shares for at least five years. There is no tax on gains and no income tax on dividends.
EIS funds provide 30% income tax relief on annual investments of up to £1m. Holdings are free from inheritance tax (IHT) after two years and there is no tax on gains.
Both types of investments are relatively high risk and lack liquidity, so it can be difficult to sell your shares.
People typically think they should draw money from their pensions in retirement, but using other assets could reduce your tax bill.
You can withdraw money from ISAs without paying any tax. You can take 25% of your pension tax-free but the rest is taxed according to your income tax rate.
Your personal assets, including your ISA, are subject to IHT when you die, whereas your pension is usually held in trust outside of your estate and free of IHT in most cases.
Each individual can gift assets or cash of up to £3,000 each year without incurring IHT. This makes it an easy way to reduce your IHT bill on death.
You can carry over any leftover allowance from one tax year to the next, up to a maximum of £6,000.
You can make larger gifts but you need to live for more than seven years so your children or family don’t pay IHT. There is no limit on how much money you can give to charity.
Set up a family investment company
A family investment company – a limited company whose shareholders are family members – can be an extremely tax-efficient way of investing money.
Profits are subject to corporation tax of 19% (or 17% from 2020) and shareholders only pay tax when the company distributes income.
It is a complex area so it’s vital to consult a tax expert.