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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 32½% taxpayer or a 40% taxpayer (or from 6 April 2010, a 42½% taxpayer or a 50% 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.

There are now four rates of income tax::The reduced rate of 10% is only availlable on small investment incomes, the basic rate is 20%, the higher rate is 40% and the additional rate is 50%.

(1) There is a maximum income limit - 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 over age 65 before 6 April 2001.

The taxman also lets you off paying tax if you have certain expenses: mortgage interest or pension contributions for example. These are called outgoings but the tax relief on outgoings is often restricted too.

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 tax on the extra amount at the 40% higher rate although the extra tax on dividends from UK shares is now 32½%.

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 is less than £2,320 - in practice a total income of £7,755, then up to £2,320 is only taxed at 10% from 6 April 2008.

From 6 April 2010 the personal allowance will be reduced for those with incomes over £100,000 a year; the allowance will be reduced by £1 for every £2 of income over £100,000 until the allowance is reduced to half. For those with incomes over £140,000 a year the allowance will be reduced further by £1 for every £2 of income over £140,000 until the allowance is eliminated. The personal allowances for 2010-2011 will be the same as they are in 2009-2010 allowance; to see examples in an official document on how this might work, click here.. There will also be a 50% rate of tax starting on incomes over £150,000 a year (originally the proposal in the Autumn of 2008 was for a 45% rate starting a year later).

The tax rate for dividends on that part of income over £150,000 a year will be 42½% instead of 10% (for basic taxpayers) or 32½% (for 40% taxpayers).

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 2007 to September 2009, then allowances and tax bands should be raised by 3% for the tax year starting on 6 April 2010. 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. The Retail Prices Index actually fell in the 12 months to September 2009 and the allowances will remian the same in 2010-11 as they were in the previous year.

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 2010-2011 tax year.

Take a person earning £35,000 a year. The first £6,475 is not taxable because of the personal allowance. Suppose you make pension contributions of £1,750 a year before tax. This is an outgoing which gains full tax relief. It cuts another slice off your income. So £35,000 minus £6,475 minus £1,500 is £26,775. This £26,775 is taxed at 20% which is £45,355 so this person is a basic rate taxpayer.

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 £6,475 plus £2,5000 which is £8,975. So £50,000 minus £8,285 leaves £41,025 to be taxed. The first £37,400 is taxed at 20%; the rest, £41,025 minus £37,400 which is £3,625 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 most of their incomes is taxed at 20%.

Their total tax bill each is basic tax of £7,480 plus higher rate tax of £1,450 which is £8,930. They will also pay about 11% national insurance on most of their earnings, see below. So on joint earnings of £100,000 a year, tax and national insurance comes to £17,860 plus £8,518 which comes to £26,378 or 26.3% of their total income.

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

There are also National Insurance contributions on earnings which are unavoidable.

Employees' National Insurance contributions for 2010-2011 are 11% on earnings of between £5,720 and £43,888 a year and 1% on any earnings above this level. The Class 2 rate for the self-employed is £2.40 a week and Class 4 is 8% on earnings between £5,715 and £43,875 a year and 1% on any excess. Employees who are members of a contracted-out pension scheme pay a reduced rate instead of 11%.

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.

Sometimes the tax position does not make much difference. Take the example of three similar sorts of investments: banks and building societies where basic rate tax is deducted from the interest; National Savings Investment Account where no tax is deducted but you pay it later; and National Savings Certificates where the interest is tax free.

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 25 March 2010

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