Tax Freedom Day: don't work for the man any longer

With an increasing number of individuals now being dragged into the 40% tax bracket we now all work for the tax man until 30 May, Tax Freedom Day, which comes three days later than last year, according to the Adam Smith Institute. 

The government is predicting the number of UK higher rate taxpayers will rise from 3.1 million in 2010/11 to 3.7 million in the 2011/12 financial year. It also expects the number paying 50% tax to increase from 246,000 to 275,000 – a rise of nearly 12%. Seldom has it been so important to make sure you are not paying any more tax than necessary.

Waste of money

An estimated £13.5 billion is likely to be wasted this year in unnecessary tax payments, up from £9 billion last year. Yet 88% of us are doing nothing about it. Research from Unbiased.co.uk, which represents 90% of independent financial advisers (IFA), reveals that the average taxpayer could save around £440 by taking a few sensible steps.

‘For 149 days of the year – from 1 January to 29 May – every penny earned by us will be paid to the taxman rather than ending up in our own wallets,’ said Karen Barrett, chief executive of the IFA search engine. Fidelity International has calculated that taking VAT and national insurance contributions into account, a basic rate tax payer now faces a marginal rate of tax of 43% on each new pound they earn and spend.

The top area for tax wastage is tax credits, with over £8.5 billion going unclaimed on child benefit, child tax credits, working tax credits and pension credits. (You can check on eligibility and how to make a claim at www.direct.gov.uk.) The second largest area of wastage is inheritance tax, with £1.3 billion being paid unnecessarily, either by making mistakes when it comes to IHT planning or failing to make any plans at all. 

Take avoiding action

Mike Horseman  of Cockburn Lucas Independent Financial Consulting suggests, ‘looking at the new Issue of National Savings index-linked certificates for higher rate tax payers as well as maximising ISA allowances for income and other investments such as venture capital trusts and enterprise investment schemes at the riskier end of the scale.’ You can shield £10,680 this current tax year from income and/or capital gains tax - £21,360 for a couple. VCTs and EIS investments offer varying income and capital gains tax benefits.

But others are more sceptical of VCTs and EIS schemes. ‘Although tax efficiency is desirable – don't let it blind you to other considerations,’ cautions IFA Harry Katz of Norwest Consultants. ‘If you are a higher rate taxpayer the siren voices of the venture capital trust providers can appear very attractive. But many of these do more for the managers than for the clients. If you invest, you want more than just your tax back.’

Age allowance trap

Horseman mentions taking steps to avoid the often overlooked ‘age allowance trap’. Age allowance clawback means that for the over 65s, every £2 of income over the age allowance limit of £24,000 for 2011-12 results in the clawback of £1 of personal tax allowance – but only down to the level of basic personal allowance of £7,475. 

This means that at income of £28,930 the over 65s derive no benefit from the higher personal tax allowance of £9,940, or £29,230 for the over 75s who enjoy age allowance at £10,090. However, certain investments such as income from Isas and some investment bonds are tax free and do not trigger clawback so it is worth checking on how you can make the most of this. Clearly, it will also pay to take capital gains within the annual limit of £10,600 (2011-12) rather than income from dividends for all taxpayers, irrespective of clawback.

Clawback also applies to those with incomes of £100,000 or more who suffer a reduction in personal allowances at the same rate of £1 of allowance for every £2 of income over £100,000 a year – whatever age you are. For those under 65, at incomes of £114,950 all benefit from personal allowances is totally wiped out.

Pension tax relief

The IFAs are surprisingly sceptical about using pensions to reduce tax bills for the average person. ‘Do of course aim for tax efficiency but don't let the tail wag the dog,’ warns David Penny of Invest Southwest. He points out that pensions are tax efficient, ‘but if it is not income in retirement that you're aiming for, it's a crazy idea! My top tip in 2011 for tax efficiency and financial planning is pay off any debt you have, including mortgages as soon as you can.’

But for high earners pension contributions can go a long way towards mitigating income tax. Sipp provider A J Bell is predicting a sharp increase in pension contributions as a result of higher income tax rates and reports lump sums rolling in. ‘We've already seen a 170% increase in single contributions into our Sippdeal and Sippcentre accounts in the first month of the financial year compared with the same period last year,’ confirmed Billy Mackay, marketing director at  A J Bell.