Personal tax - the basics
There are various elements to take into consideration when it comes to personal tax planning and reducing your tax liability. These include:
Any personal allowance that is unused at the end of the tax year cannot be carried forward, so it is normal to ensure that so far as possible these allowances are covered by your income.
This is particularly relevant to couples where income taxable on one might be covered by personal allowances if received by the other. However, it is not possible just to ‘gift' the income in any year to a partner as tax law prevents obvious avoidance of this nature, so below are some practical ideas together with their limitations.
- Couples can own an income-generating asset jointly. The income from the asset will be assumed to be received 50% each, even where that is not the case. If this suits your arrangements you need do nothing at all. If, however, the underlying asset is owned in any other proportion and you would like the same split to apply to income then we can notify HMRC for you and the income will be taxed in the proportion of the underlying capital ownership. It is not possible to use this rule if you are neither married nor civil partners and the asset must be jointly owned for this to work. It is not possible to allocate income in any other way, for example with the husband owning the asset 95% but the wife taking 95% of the income.
- If you want your partner to take all of the income from an asset it is necessary to transfer the asset into their name. Although it is perfectly acceptable to use this technique to transfer income between individuals, do remember that once given to the partner the asset is then owned by them and is theirs to do as they wish with it. It is also important when reallocating assets in this way to be aware of the inheritance tax (IHT) implications. Transfers between spouses and civil partners are tax free for IHT, but it might mean that one partner cannot use their entire nil rate band in their estate. See more about this in Inheritance planning. Couples who are not married can also use this, but the IHT implications must be considered more carefully, and there might be a capital gains tax liability on the transfer.
- Where a couple jointly own a business as either a partnership or limited company, there is in place anti avoidance legislation designed to prevent very obvious cases of income shifting between the couple. It is not possible to transfer income between spouses by allocating preference shares to one spouse, but if the ordinary share capital is owned in equal shares, then any dividends paid on the shares do not fall foul of the legislation. Generally speaking unmarried couples can use this technique, provided the income passed between them does not benefit the original owner after the transfer or issue of the shares.
- If one partner has a business but does not wish to transfer it into joint names, it might be possible to pay the other a salary from the business and obtain a tax deduction for it against the profits. The salary must be appropriate for the services provided, so should be no more than would be paid to an unconnected person doing the same work. As well as providing a modest income for the partner it could also protect their state pension rights if they are not working in any other capacity. A salary of £7,400 per annum would cover most of the personal allowance of the recipient but would not attract national insurance contributions (NICs). However, as it exceeds the Lower Earnings Limit for NIC it is reported to HMRC at the end of the year on the annual payroll return (form P35) and qualifies as one year's credit for state pension - both basic and earnings related elements.
- If the employed partner plays an active role in the business it is also possible to make pension contributions on their behalf, which once again would be tax deductible. HMRC's guidance indicates that provided the total remuneration package - that is salary, plus benefits, plus pension contribution - is at a commercial rate, then it will attract a tax deduction against profits. If the employed partner does not wish to draw a high salary because of the liability to NICs, they might wish to draw a combination of low salary plus a pension contribution. Provided the total represents no more than a market rate salary for the role, this will qualify as a tax deductible cost for the business.
The quantum of income you might wish to consider switching will depend on your personal circumstances. Here are the basic rules:
- The personal allowance for 2012/13 is £8,105 and so ideally you will wish to ensure that this is fully utilised.
- Remember that tax credits are not repayable on dividends, so there is no benefit in using dividend income to cover personal allowances, although it can be used to transfer income from a higher rate taxpayer (who will bear an extra 25% on it, or 32.5% if their incomes exceed £150,000) to a basic rate taxpayer, who will have no extra tax liability.
- If you are 65 or over your personal allowance is £10,500 (£10,660 for those 75 and over). However, this allowance reduces to the normal personal allowance if your income exceeds £25,400, by withdrawing £1 of additional allowances for each £2 of income over the limit. This means that taxpayers in this position suffer a marginal rate of 30% tax on income between £25,400 and £30,190 (£30,510 for 75 and over). Transferring income from the partner in this band is therefore particularly useful.
- Taxpayers entitled to age related personal allowances can also reduce their income for the abatement calculation by making donations to charity or making contributions to a pension. Small donations to charity during the year can mount up, and many taxpayers overlook the importance of reporting them on the tax return. Keep a record of all charitable donations you make to ensure that you receive full benefit for them. If paying into a pension, gross contributions of up to £3,600 can be paid in any year in which you have no earnings (£2,880 net). In addition to potentially saving tax at 30%, the pension benefits could be drawn immediately by taking a 25% tax free lump sum.
- Children have their own tax allowances and can use these against their own income, but anti avoidance law prevents parents from transferring investments to unmarried children under 18 so that they benefit from the income tax allowances. No more than £100 of income can be transferred in this way.
- If children are employed in a business owned by the parent then income can be paid to them as wages. This is an acceptable route to take provided legislation designed to protect children from exploitation is observed. NICs will be due on the wages paid that exceed the limit (currently £144 per week) once the child is 16. You must observe normal PAYE obligations when you employ a child, so they should complete form P46 and you should add them to the payroll.
- Interest added to a Junior ISA is not taxable on the child or the parent even where the invested funds come from the parent. Contributions of up to £3,600 can be made each tax year. Most providers have a minimum contribution limit of £10 per month.
- Tax credits are available to couples who are working at least 24 hours a week, although if you do not have any children under 16 in the household (or up to 18 if still at school) you will need to be working for 30 hours a week. Where you claim as a couple, these hours can be shared between them, provided one works at least 16 hours. Single parents must be working at least 16 hours a week.
- For a couple claiming for themselves only, the entitlement to tax credits ends at an income level of £18,000, but if your income this year has been reduced by either the recession or claims for Annual Investment Allowance on purchase of business assets, then a single year of very low income could give rise to two years in which tax credits can be claimed. Awards are also higher for families with a disabled worker.
- Tax credit awards cannot be backdated by more than one month so you must claim early in the tax year to get the full entitlement for the year. Once you have started claiming, a renewal pack is sent out at the end of the year. This allows the claim to ‘roll on' from one year to the next.
- Changes in circumstances such as giving up work must be notified within one month. If you are late telling HMRC about a change that adversely affects your entitlement you can incur a significant amount of tax credit debt, which in some cases can be demanded in a single payment demand.