Death and Taxes

Reading Mr Money Mustache’s take on the low tax burden for those living the frugal retired lifestyle has prompted me to review my own level of tax efficiency.

While not yet retired myself, I’m fortunate enough to be compensated for going to work with a sizable income.  Only last week I received my P60 providing a summary for UK tax payers of the Income Tax and ‘National Insurance’ (i.e. income tax) paid on employment earnings in the previous tax year.

For the first time in my career, taxable earnings exceeded £100,000.  Obviously, it would be churlish of me to complain about that, but I mentally kicked myself at allowing it to happen.

Why?

Taxable earnings are not the same as earnings.

There are steps that can be taken (legally I hasten to add) to keep taxable earnings to a minimum.  The trouble is, I seem to fall into a Bermuda Triangle of information on how to achieve this.  At the higher end of the earnings spectrum, accountants and other tax planners are frequently employed to assist.  At the lower end, there are many forums to be found at the click of a mouse advising on the best way to ensure all benefits, tax-credits and allowances are claimed.

I think my financial affairs are straight-forward enough to be able to manage this myself (Insourcing my own financial advice) and save myself a few hundred quid in fees, I have no interest in pursuing the more aggressive tax-planning that can lead to an uncomfortable chat with the chaps at HMRC, and I’d rather learn how to do it myself.

This chart shows the UK tax rate inclusive of both Income Tax and National Insurance but ignores the effect of tax credits and other benefits that would be of more interest to those at the lower end of the earnings scale.

What the hell is going on at £100-120k?!?

I now find myself perched on top of that 62% tall column in the middle of the chart.  Am I really such a fat cat that I deserve to be taxed at a higher marginal rate than those earning   £150,000 or higher?

This bizarre quirk is the effect of a rather idiotic change to the tax code which withdraws the personal tax allowance from those earning more than £100k pa.  For every £2 earned above that amount the personal allowance is reduced by £1, dwindling to nothing at £116,210.

So what can be done?

Very little, as it happens.  If you are paid via PAYE (Pay [tax] As You Earn, where taxes are deducted at source) there are in fact precious few options available.  Despite popular misconceptions about fat cats failing to pay their dues, it’s nigh on impossible to avoid tax as an employee.

Here are some of the precious few methods I have found.  If anyone knows more, please comment below.

Pension contributions

This is probably the best one for a higher or additional rate tax payer.  Contributions can be made to a pension plan out of pre tax income.  This is what I should have done more of to get me below that crucial £100k limit.

For every £100 I put into my pension, I needed only to give up £38 of post-tax income at the highest marginal rate of 62%.  Although I can’t touch the money again until I’m 55 (and assuming there are no future legislative changes delaying the option still further) I get a day one investment return of 163%.  Not bad!  Admittedly, once I draw my pension it counts at taxable income, but I’m likely to be paying tax at a much lower rate than now.  What’s more, I can take out 25% of my fund tax-free once I retire.

So my notional £38 plus its tax rebate will grow over time, assuming a 2% real (post-inflation) investment return for the next 23 years (taking me to 55) to just under £158.  I’ll then be able to draw down £40 tax free and still have £118 to either draw down over time or convert to an annuity i.e. a stream of payments for the rest of my life taxed at 20%.

Quite a good deal.

Pension legislation can move quite quickly so I’ll need to keep a close eye on this strategy but for now it remains the best option.

Share Incentive Plans

For those working for a listed employer, a Share Incentive Plan can provide a tax efficient route to owning shares in their employer.  Up to £125 per month of pre-tax, pre-NI income can go towards purchasing shares in the employer’s scheme.  Here’s what HMRC says.

There are some conditions on the length of time the shares need to be held to receive the tax breaks in full but generally speaking for a 40% (or 50%) rate income tax payer, £125 worth of shares can be acquired for just £72.50 (or £60.00) each month.

Save As You Earn

A related strategy is the Sharesave plan.  This is a savings contract where employees put aside between £5 and £250 per month are offered the option of purchasing shares at a specified (usually discounted price) after a fixed savings period of three or five years.

Here’s the guidance from HMRC again.

Ermine at the Simple Living in Suffolk blog did a good piece on the benefits and pitfalls of these types of share plans.

Charitable giving

I’ve been in the position of being able to step up my charitable giving over the last few years as my income has grown.  The relevance to this post is that it’s all tax deductible thanks to the recent U-turn.

I might come back to this topic when I do my tax return later in the year.

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3 thoughts on “Death and Taxes

  1. Some ideas DYOR of course but:

    You might want to investigate EIS and VCT schemes but they do come with an extreme wealth warning. Mind you, you can take on a shedload of risk if you are only foregoing 50% of the stake 😉 SIP is a no-brainer but only a small amount, £1500 p.a. at my company. If you think your firm SP is dodgy there is the option of shorting the SIP stake to derisk it.

    Sharesave isn’t strictly speaking tax-advantageous since you pay for it from post-tax income, but it’s kinda rude not to take a free one-way bet. Thanks for the hat tip!

    The pension is the real winner here however pension savings favour people in the 10 years coming up to 55. I am probably three years from drawing my pension, when I started saving it was six years away. Those early savings of 41% extra are an effective interest rate of 7% p.a. on the savings (41% divided by 6 years) and last years are effectively over 10% p.a. You would run, not walk, to get that sort of risk-free return nowadays. Those returns aren’t so relevant for younger savers, but OTOH if you’re younger then you can invest part of your fund on the stock market, gradually winding it back to cash in the 10 years before retirement.

    You’re probably doing ISAs already but it’s something I missed. You want to be maxing your S&S ISAs over several years to retirement as the income is tax free unlike your pension. Sadly you need a ISA fund of about 20 times your target income so at current ISA limits you can only buy yourself a tax-free income of £500 a year. So if you start at 45 you’ll have enough to buy a tax-free income of about £5000 p.a. to add to your pension without eating into your personal allowance (hopefully 10k+ by then). Obviosuly YMMV and you may be a better or worse investor; the 5% seems to be a general rule of thumb that I seem to be able to replicate so far.

    • Thanks Ermine.

      I might need to expand my Sharesave analysis but I thought that the tax break came at the exercise of the options (assuming they have value at the end). Any difference between market value and the option price is Income Tax and NI free. Also there’s a nice CGT break too.

      S&S ISAs are the biggie for post-tax income. I’m currently weighing up the options between the various providers to get a portfolio together. One each for me and the wife means double the tax shelter but double the fees. I read your post about iii getting ready for RDR with a new gouging price structure. Perhaps I’ll wait for the dust to settle before I take the plunge.

      As for returns, I’m working on the principle that I can make 2% p.a. after inflation. Hopefully it’ll be a bit more than that but I’m just building in a bit of a buffer into the calculations.

      One point to add to your great article on locking in profits on share options is the pitfall awaiting certain individuals who work in UK financial services. Certain awards are subject to the FSA provision that the recipient specifically does not take steps to hedge the risk. I think the intention is that certain payments e.g. deferred bonuses (*wince* – I’ve just remembered your thoughts on those!!) should quite rightly remain ‘on-risk’ until vesting.

  2. Pingback: Why I reuse my poppy | The Edge of Cultivation

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