Mind the tax trap!

09.04.2021

How to kill two taxes with one stone (ok, maybe not kill exactly)

I am under no illusions that an article on tax is going to capture the imagination but please bear with me!

Now that we are at the start of a new tax year, there is one particular area I wanted to bring to your attention. Don’t worry I have no intention of staring into a tax crystal ball and predicting what may change in the future.

There are however two well-established tax traps that are all too easily missed but, in many cases, can be equally easily avoided if you know where to look. It is also possible to help a child or other family member avoid them which creates a win-win against both Income Tax and Inheritance Tax.

The first is the snazzily titled ‘High Income Child Benefit Tax Charge’. Imagine, if you will, someone a bit like me but only in so far as they are married and have 2 young children. If either my wife or I earned over £50,000 then not only would we start paying higher rate tax but we would also have to start paying back child benefit.

Now, imagine my wife earns £60,000. If she did then not only would she have paid 40% income tax on the income between £50,000 and £60,000 but she would have to repay the child benefit in full which is another £1,820 giving a total effective tax rate of 58.2% and leaving her walking away with just £4,180 in her pocket from £10,000.

Imagine, instead that you could turn that £4,180 back into £10,000 and the only catch is that it was in a pension to help fund her retirement. That’s a pretty attractive 239% return!*

The detail of how this works is below but I think it is important to make people aware of this. From experience, if that were indeed my wife, cashflow can be tight with 2 children but there is no reason why a parent couldn’t make this contribution on behalf of an adult child. If this were treated as a gift either out of income or by using the £3,000 annual Inheritance Tax (IHT) exemption then it is win-win as it also helps pass money to the next generation efficiently as far as IHT is concerned.

The second trap I want to cover is the loss of Personal Allowance for income exceeding £100,000. The ‘trap’ in this case exists for people earning between £100,000 and £125,140. For every £2 of income above £100,000 then £1 of personal allowance is lost.

This creates a punitive tax rate of 60% for this section of income. This comes from 40% income tax and an 20% extra tax for the amount of lost personal allowance.

I’m sure you get the idea now with pension contributions, but this can be another point at which pension contributions become incredibly tax efficient.

I will leave it there for now. If you think this could affect you, a family member or someone you know why not get in touch with your Planner and see if we can help.

*In practice the individual would make an £8,000 initial outlay into the pension. The scheme would reclaim £2,000 within the scheme giving a total of £10,000 in the pension. Higher rate tax (a further £2,000) would be reclaimed via a tax return taking the net cost to £6,000 and the Child Benefit of £1,820 can be kept making the net cost £4,180.

Dan Hiles
Financial Planning Director & Chartered Financial Planner