With share and property prices tumbling, protecting your wealth has rarely been trickier and now the Chancellor, Alistair Darling, has introduced a new 50% income-tax rate on high earners. Cutting your tax bill has never mattered more, says Tim Bennett. Here’s how you can do it.
1. Make a will
On death, all of your assets – no matter where they are located – form part of what HM Revenue & Customs (HMRC) calls the death estate. That’s given a ‘probate’ value before being hit for 40% inheritance tax (IHT). Fortunately, the first £325,000 is exempt for the 2009/ 2010 fiscal tax year (6 April 2009 to 5 April 2010). What’s more, a couple can claim one £325,000 exemption each, with any unused portion being transferred automatically to the surviving spouse.
Without a will, the assets of a wealthy couple won’t automatically be distributed in the most tax-efficient way, but according to the intestacy rules. This is a particular issue where their joint estate exceeds £650,000 (the joint IHT exemption). Wills can be amended retrospectively via a deed of variation within two years of death, if all the surviving beneficiaries agree. This option is risky as the rules could change anytime.
2. Shrink your estate before you die
Few people want to leave 40% of their death estate to HMRC. The trick is to reduce it before you die. You could spend all you have and leave no estate – you may decide the children can fend for themselves once you’re gone. An alternative is to make gifts and try to ensure your estate falls below the exemption threshold when you die. For example, anything (whether assets or cash) you give away at least seven years before death escapes IHT entirely.
But be warned – if a father gives away, say, a second family house to his son, there will be a separate capital-gains tax (CGT) liability if the house has risen in value since it was acquired. And you can’t continue to make use of an asset once you’ve gifted it (not if you want to avoid an IHT bill anyway). So always take advice before making gifts of assets.
You can make regular cash gifts of any size out of income to anyone, as long as they do not reduce your overall standard of living. Small gifts are exempt too – you can give away gifts of below £250 to as many different people as you like every year tax-free. Beyond that you can also give away up to £3,000 a year to any one other person tax free. And wedding gifts are exempt too – up to £5,000 can be gifted by a parent, £2,500 by a grandparent and £1,000 by anyone else.
3. Use your Isa allowance
Don’t forget about this, as it works on a use it or lose it basis. An Individual Savings Account lets you shelter cash and dividends (beyond the first 10%), plus interest income on bonds from income tax; and also shares and many bonds from CGT. For the current tax year, anyone over 16 for a cash Isa, or 18 for a stocks and shares Isa, is eligible to invest. The maximum cash Isa investment for this tax year (ending 5 April 2010) is £3,600. The maximum for stocks is £7,200, as is the total annual Isa limit.
Now for Alistair Darling’s latest Budget twists. From 6 April 2010 the annual investment limit rises to £10,200, with the cash component capped at £5,100. If you are over 50, these higher limits kick in from 6 October 2009. If you fancy investing now, there’s no need to wait; you can invest up to £3,600 in cash before October and then top up to the £5,100 limit after that date. You can even transfer your Isa to another provider later in the year should you spot a better deal.
4. File tax returns on time
All higher-rate taxpayers have to complete annual tax returns. These can be done on paper, but the deadline is 31 October, assuming notice to complete one was sent out by HMRC before 31 July. Otherwise you have until the later of 31 October, or three months after the notice is issued. You can buy more time by filing online, but you have to notify HMRC first. Then the deadline becomes 30 December if you want HMRC to collect unpaid tax via your tax code, or 31 January if not. Filing late incurs a £100 fine, which can now rise to £1,000 if you are more than three months late.
5. Use gift aid
This just requires you to declare your name and address and give your consent when making a donation to charity. Gift aid allows both you and the charity to reclaim tax on the amount you give. The hike in the highest tax rate to 50% for those earning over £150,000 from next April makes this relief all the more valuable. The donor will be able to reclaim £37.50 on every £100 donated, which they can opt to gift to the charity.
6. Get a lodger
You can rent a furnished spare room, or even a spare floor, in your main home income-tax free, provided the rent does not exceed £4,250 per tax year. This also does not affect the CGT exemption on your ‘principal private residence’ when you come to sell.
7. Split assets efficiently between spouses
If you don’t earn a salary you can opt to have the interest income on your savings from a bank or building society paid tax-free. You just have to fill out the R85 form. So it also makes sense for a couple to ensure that savings and investments are transferred to, and held by, the non-earning spouse. Around £114m was lost last year by married couples who failed to do this and thus needlessly lost around 20% of their savings income as a result.
8. Keep a note of your losses
With prices for shares and properties falling and the first £10,100 of profit protected by the annual tax-free allowance, CGT may not be a major worry for many just now. But don’t forget to keep a note of losses. If you sell, say, shares for less than you paid, you can’t claim any tax back, but you can carry forward the loss for use against future gains. So keep a careful record.
9. Swap income for capital
For higher-rate taxpayers, a CGT rate of 18% is much more attractive than the new top income tax rate of 50%. One way to take advantage is via employee share schemes, says Stephen Herring of accountants BDO Stoy Hayward in The Times. For example, if an executive is granted share options worth £100,000 they will still be taxed as income when exercised. But the resulting gain of, say, £400,000 (assuming the open market value of the shares is £500,000) is taxed at 18%. If the same executive is paid a £500,000 bonus instead, once the new rate kicks in the whole amount will be taxable at 50%. Another option is ‘zeros’ – preference shares that don’t pay income, but (hopefully) rise in value, triggering tax at 18% rather than 50%. But take advice first as HMRC is clamping down on anything that looks like a tax avoidance scheme and has both of these in its sights.
10. Become a company
A good move for high-income freelancers, contractors and consultants, provided they pass HMRC’s criteria. If a firm makes annual profits of below £300,000, the corporate tax rate is just 21%. But if you own shares in an existing profitable company, the top tax rate for dividends is 32.5% until 5 April 2010 and 42.5% afterwards. So crack on if you plan to pay yourself a dividend.
11. Top up your pension pot
Retirement is an increasingly expensive prospect for those relying on money-purchase private pensions rather than final-salary schemes. So every tax break counts. For higher-rate taxpayers earning up to £150,000 a year, the ability to claim higher-rate relief at 40% on contributions to a private pension is useful. Indeed, in most cases, it’s probably sufficient compensation for the fact that you can’t draw more than 25% of your final fund out as a lump sum on retirement – the rest buys an annuity – and you can’t currently draw so much as a bean before you hit 50. You do need to ensure your total pot doesn’t exceed the maximum lifetime fund limit – currently £1.75m. If it does, part of your 25% lump sum could be hit for a 55% charge, while any excess income will be hit with a 25% surcharge and income tax.
But the Budget held more bad news for high earners. Higher-rate relief on contributions for those on more than £150,000 will be capped from 2011, with relief being tapered down to 20% for those on between £150,000 and £180,000. And due to anti-avoidance measures you can’t rush big contributions through before then, or swap salary for pension contributions (‘salary sacrifice’ – see below). “If something was in place before the budget it can stand, but those earning over £150,000 can’t do anything new,” says Andrew Tully, senior pensions policy manager at Standard life in the FT.
12. Sacrifice salary
As well as the higher charges on those earning above £150,000, there was a sting for those earnings over £100,000 a year: a cut in the tax-free income personal allowance. For now, every UK taxpayer can earn a fixed amount of income, tax free – for this tax year, it’s £6,475 for the under-65s. But from 6 April 2010, anyone earning more than £100,000 will lose £1 of allowance for every extra £2 of salary. So once you hit a salary of £112,950 – £100,000 + (2 x £6,475) – you will receive no personal allowance at all. According to the Institute for Fiscal Studies, this means anyone on £100,000 to £106,475, or £140,000 to £146,475, will suffer a marginal rate of income tax of 60%. So what to do?
On over £150,000, there’s not much room for manoeuvre due to anti-avoidance measures. But for those on £100,000-£150,000, salary sacrifice to boost your pension is an option. You agree with your employer that, via a change in your contract, some of your salary will be swapped for a non-cash benefit, such as a a higher pension contribution. That saves an employee the 11% national insurance that would have been due on the equivalent extra salary. If salary sacrifice takes a high-earning employee’s pay back down to below £100,000, they could avoid the tapering down of the personal allowance for income tax.
13. Relocate, relocate
If drizzly weather and creaky transport systems don’t put those earning more than £150,000 a year off Britain, the 50% tax rate might, particularly with the anti-avoidance measures in place. If you do decide to up sticks and move to another country, you’ll want to become a non-UK resident. There is no universally agreed legal definition of what HMRC calls “UK residence”. Until recently you could rely on some simple tests. For example, if you live outside the UK and don’t return either to spend 183 or more days in any single tax year, or 90 days a year or more on average over a four-year period, you have normally been eligible for “non-resident” status. You need to choose your days in Britain carefully – the October 2007 Pre-Budget Report confirmed that arrival and departure days usually count towards the totals.
But as Heather Taylor, a tax senior manager at accountants Grant Thornton cautions in Accountancy Age, this set of “quantitative rules” is under review. The determination of non-residence is now “qualitative” – HMRC may apply a range of factors, including the number and type of family, social, property and business connections you maintain here. A “settled lifestyle pattern” in, say, London, may point to UK residence irrespective of the days spent in the capital. So, once again, take advice before making an assumption. If you can be classified as a non-resident, you can often avoid income tax on non-UK income, and virtually always avoid CGT on non-UK gains.
That leaves the question – where do you move to? There are traditional havens such as Andorra, Jersey or the Isle of Man, says Matthew Lynn, writing for Bloomberg. He also suggests four other options. Monaco has no personal income taxes, but “the place is crowded and expensive”. Geneva’s top rate of tax is 40%, “but can be a lot less if you aren’t Swiss,” although while the quality of life is good, it’s “expensive”. The more adventurous might want to try Bulgaria – with a top tax rate of “just 10%”, it has “one of the most pro-business fiscal regimes in the world”. Or if you really want to push the boat out, you could try Macedonia. It also has a top tax rate of 10%, but the downside is a “slight tendency toward civil war”.
Three tax-efficient investments
You should never invest purely based on the tax breaks. But it’s always worth being aware of what’s available if you are interested in an asset class.
A windfall on holiday lets
Under pressure from the European Union to equalise the treatment of furnished British and overseas holiday lets, Alistair Darling has dealt many British second homeowners a big blow. From 2010, qualifying furnished UK holiday lets (which have to be available for let for 140 days a year and actually let for at least 70) will no longer be treated as business assets. That hits the ability to claim loss relief against other income – most owners make a loss of around £10,000 once costs are deducted from rental income, according to Myra Butterworth in The Times – and to defer CGT.
But it’s great news, short term at least, for owners of overseas furnished lets who meet the occupancy tests. They can apply retrospectively for up to five years’ worth of tax – in essence, the amount they could have saved had the tax break on British lets been available to them.
But don’t hang about if you think this applies to you, and if you don’t already own a holiday let, don’t buy one now – from April 2010 the break will disappear altogether, on any furnished holiday lets owned by British residents. Finally, you could shelter a holiday let within a company to maintain some of the tax breaks, but seek advice first.
Back small firms
For anyone prepared to stomach the risk, venture capital trusts (VCTs) invest in Aim stocks and unquoted firms, offering tax relief at 30% on investments of up to £200,000 a year if you invest for five years. Enterprise Investment Schemes (EIS) offer relief of 20% on up to £500,000 invested a year, as long as you stay in for at least three. Gains are tax-free under both schemes. But understand that these are risky investments – some VCTs, for example, are down 90%, according to Trustnet. And the short-term outlook for small firms, as credit remains tight and consumers retrench, is pretty bleak.
Get into European farmland
The farming industry got a surprise boost in the Budget from a decision to extend Agricultural Property Relief (APR). It now applies not just to UK property, but also across the European Economic Area (the EU plus the likes of Norway, Iceland and Liechtenstein). An extension has also been granted to Woodland Relief. The effect of APR is to cut the IHT value of assets by either 100% (subject to tough conditions being met governing how the land and buildings are used), or 50% otherwise.
There are other reliefs for qualifying land and buildings, such as the ability to roll over capital gains where an owner intends to reinvest the proceeds of a sale. But whether you want to invest in European farmland or forest is another matter: you’ll have to navigate local rules on ownership and mortgages (should you need one) and tax, plus the sterling/euro exchange rate.