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Keeping Down Your Tax Bill

To choose the right investments, you have to invest by the best way for your own personal tax position. This Chapter tells you how to work out what rate of tax you pay: whether you are a non-taxpayer, a 10% taxpayer, a 20% taxpayer, a 40% taxpayer or a 50% taxpayer. If you hold shares, you could also be a 32.5% or 42.5% taxpayer. Before you take any investment decision you need to know what rate of tax you are liable to pay.

Income tax

Everyone has heard of income tax. Most people would prefer not to pay it. But lots of people pay more than they need, especially on their savings, through not knowing how the system works.

You don't pay tax on all your income. The taxman lets you off paying tax on the first so many pounds. How much depends on whether you are married, single, divorced or widowed and whether you are a one parent family. Elderly people on small incomes also pay less tax.

This income, on which you don't have to pay tax, comes under the heading of allowances. Everyone is entitled to a personal allowance or personal age allowance. Other allowances are given in addition. All are listed in the table below. Some allowances listed here give tax relief at your highest rate; others marked with a footnote, now only give 10% relief.

(1) There is a maximum income limit (£24,000 a year in 2011-12; £25,400 in 2012-2013) - see Boosting Your Retirement Income. (2) Tax relief at 10% only. Only one married couple's allowance per couple. Only available if either spouse was born before 6 April 1935. (3) Since 6 April 2010, the personal allowance is reduced by £1 for every £2 of income per person over £100,000 a year until it is extinguished.

The taxman also lets you off paying tax if you have pension contributions or make donations to charity through gift aid.

Some forms of income are exempt from tax: these are listed overleaf. Others which are taxed differently are explained in How Different Types of Investments Are Taxed.

Having deducted your allowances and allowable outgoings (and ignoring income exempt from tax), the taxman taxes your income up to a certain level at the basic rate which is 20%. If your income is above the basic rate level, you usually have to pay higher rate tax on the extra amount at 40% although the extra tax on dividends from UK shares (32½% for share dividends). Since 6 April 2010 there is an additional rate on incomes over £150,000 a year which is 50% (42½% for share dividends).

Exceptions to these tax rates

• Dividends from shares come with a tax credit of 10%, so they are taxed at 10% rather than 20% if they form part of your basic rate band.
• if your taxable income in 2011-2012 is less than £2,560 - ie your total income was less than £10,035, then up to £2,560 of bank and building society deposit interest and share dividends is only taxed at 10% for tha tax year. The figure for 2012-13 will be total income under £10,815.

Since 6 April 2010 the personal allowance has been reduced for those with incomes over £100,000 a year. The allowance is reduced by £1 for every £2 of income over £100,000 until the allowance is eliminated.

The amount of income tax allowances and the levels at which the higher rate of tax begin to apply can change from year to year. In theory they are automatically linked to the rise in the official Retail Prices Index for the previous year to September. So if prices go up by 3% from September 2011 to September 2012, then allowances and tax bands should be raised by 3% for the tax year starting on 6 April 2013. The Government can decline to follow this rule in its annual Budget. Or it can raise the allowances and tax bands by more. The Government has another measure of prices called the Consumer Price Index which at present rises at a different rate but is not used for this calculation.

Knowing your tax rate

Most people with jobs are basic rate taxpayers. Retired people may not pay tax if their main source of income is the State Retirement Pension. If you have a large income, you pay higher rate tax.

What tax rate you pay depends on your income. But when you decide where to invest, also think whether the income from that money will put you into a higher tax band. The tax rates and bands mentioned in the following examples are for the 2011-2012 tax year.

Take a person earning £35,000 a year. The first £7,475 is not taxable because of the personal allowance. Suppose you make pension contributions of £1,750 a year before tax. This gains full tax relief. It cuts another slice off your income. So £35,000 minus £7,475 minus £1,750 is £25,775. This £25,775 is taxed at 20% which is £5,155. So this person is a basic rate taxpayer. What is more the average rate of tax payable is 14.7% .

However if the person in the example above is an employee, there are also National Insurance contributions. Most people pay the non-contracted out rate which since 6 April 2011 is 12% of the amount over £102 a week (up to a maximum of £817 after which the rate is 2% of the excess). In the above example the amount of NI would be £3,563 a year, an average rate of 10.2%. So this employee pays on average 24.9% of his or her salary to the Government.

The tax treatment is exactly the same on your own income whether or not you are single or married or have entered a civil partnership (a form of marriage for same sex couples).

Now consider a more wealthy set-up. Suppose a couple each has an income of £50,000 a year. Each makes £2,500 pension contributions. So each has allowances and outgoings which total £7,475 plus £2,500 which is £9,975. So £50,000 minus £9,975 leaves £42,025 to be taxed. The first £35,000 each is taxed at 20%; the rest, £42,025 minus £35,000 which is £7,025 is taxed at 40%. So any extra income from investments is taxed at 40%.

Therefore both husband and wife (or each partner if they are not married) are higher rate taxpayers even though £84,000 of their joint income together totalling £100,000 a year is taxed at 20% and only around £14,000 is taxed at 40%. If they are both employees then they also pay National Insurance contributions totalling about £9,000 a year. So they pay a higher share, 28.5% of their joint income to the Government..

However if the one of them has an income of only £30,000 a year, then he or she is a basic rate taxpayer - while his or her spouse or partner is a higher rate taxpayer. In that case there would be a tax advantage in transferring high yield investments to the lower earner's name; see Wives' Income and Investments. If your earnings or pension put you close to the limit where tax starts, or the higher tax band starts to bite, then you need to work out carefully whether you are liable for tax on your investments and at what rate. If you are 65 or over during the tax year, see also Boosting Your Retirement Income

National insurance contributions

National Insurance contributions on earnings are unavoidable.

Employees' National Insurance contributions for 2011-2012 are 12% on earnings for most people over £5,304 a year but are only 2% on any higher earnings over about £43,000 a year. Employees who are members of a contracted-out pension scheme pay a reduced rate. Self-employed people who are sole traders or members of a partnership pay less. Go to H M Customs & Revenue for full details. The Government has promised to change the basis of pensions which may end up with everyone paying the same rates of national insurance in order to get the same pension.

Minimising your tax

Often minimising your tax is the best way of maximising your investment return. In Part 2, each investment described tells you whether it's suitable for non-taxpayers 20% or higher rate taxpayers.

Where tax is not deducted from interest that does not mean it is tax free although if your allowances are equal or gretaer than your income you will have no tax to pay later.

For basic rate taxpayers it may be as important to consider other factors in addition to the tax saving. These are:

• convenience: whether you want the money back easily or prefer to tie it up for a longer period to obtain a higher return.
• whether you expect interest rates to rise or fall over the period of your investment (if you expect them to fall, you should choose an investment where the interest rate is fixed).
• how secure or risky the investment is.

How much the extra tax reduces your return can influence you, as a higher rate taxpayer, in favour of a tax free investment.

Non-taxpayers should consider investments where tax is not deducted because it saves them the trouble and delay of claiming a rebate. 10% taxpayers pay the tax later but can't claim a rebate on some forms of investment.

Last updated 6 January 2012

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