Are you paying more tax than you need to?
You might not know it yet, but you could be paying more in taxes because of a phenomenon known as ‘fiscal drag’. The failure of higher and top-rate tax thresholds in Scotland or the Child Benefit and Personal Allowance thresholds for the whole of the UK to rise at least in line with inflation is catching more and more taxpayers unaware, see table below.
Scottish Higher Rate Tax threshold
High Income Child Benefit threshold
Personal Allowance threshold
Top Rate of income tax threshold
The table above shows how little if any of these tax thresholds have increased over the last few years. As people’s incomes increase these thresholds are catching more and more taxpayers and can lead to far higher tax bills than they may have been expecting.
What are these thresholds?
These are the levels of earned incomes over which additional taxes may become payable. Scottish higher rate tax, and to an extent top rate tax, are relatively well known and are the levels at which you will start to pay higher levels of income taxes, 41% for higher rate and 46% for top-rate tax.
The High-Income Child Benefit threshold comes in where someone in a household claiming child benefit earns more than £50,000. Child Benefit begins to be withdrawn by way of the high-income child benefit tax charge and the benefit is cancelled out completely once earnings reach £60,000. This could mean losing out on £1,790 p.a. for a family with two children.
The personal allowance threshold is where earnings above £100,000 starts to reduce your personal allowance, (which for this tax year is £12,500), by £1 for every £2 above £100,000. Earnings above £125,000 completely lose any entitlement to a personal allowance, which adds £2,500 to your tax bill.
What can be done?
There are steps you can take to reduce the amount of Scottish top rate or higher rate income tax, or at least reduce the amount of higher rate taxes you have to pay. These techniques can also help prevent you from losing child benefit or your personal allowance.
Make pension contributions
Pension contributions qualify for income tax relief at your highest rate and in effect reduce your income used to determine the High-Income Child Benefit and Personal Allowance thresholds.
For example, if you earn £46,430, some £3,000 would be liable to a high rate tax at 41%. However, if you make a gross pension contribution of £3,000 this has the effect of keeping you outside the clutches of higher rate tax. You will receive immediate tax relief on the contribution of £600, so you only actually need to pay £2,400 into the pension, and you can claim a further £600 in tax back from HMRC.
The same is true with the child benefit and personal allowance thresholds. For example, if you had earnings of £55,000 and qualify for child benefit, making a £5,000 gross pension contribution in effect reduces your income back to £50,000 where you would receive the full child benefit allowance, rather than only 50% if you didn’t make a contribution. You would also receive immediate tax relief on the contribution of £1,000, so you only actually need to pay £4,000 into the pension, and you can claim a further £1,000 in tax back from HMRC.
There are limits to how much can be paid into a pension, particularly for people earning more than £150,000, so you need to check eligibility before making a pension contribution.
Sacrifice your salary
Another tack is to opt to sacrifice your salary in exchange for another benefit, such as extra pension contributions or childcare vouchers if your employer offers this option. Bear in mind that this does involve a genuine reduction in salary, so any other transactions based on salary, such as death in service benefit, could be affected too.
Give to charity
Donating to charity via Gift Aid is an effective strategy to reduce a higher rate tax liability or help keep your Child Benefit and Personal Allowances, like payments to pension schemes, charitable donations are tax-deductible and can help restore your allowances.
There are tax planning options available to you that can help reduce your tax burden, particularly if you have found yourself on the wrong side of one of the various tax thresholds. Spending a little time on your finances can help save you thousands of pounds in taxes.