The new personal allowance and dividend allowances introduce the potential for two new forms of tax-free income. By maximising these, couples could enjoy at least £34,000 of tax-free income a year and that ignores Isa income.
Unless stated otherwise,the rates illustrated are those for the tax year 2016/2017 as currently announced. As we see with all too much regularity, taxes and these allowances change.
Personal allowance – the first £11,000 of taxable income per person is tax-free
The personal allowance is an important tax break. Couples can spread their investments between them to ensure that they fully use both personal allowances, potentially providing a combined £22,000 of tax-free income a year.
To give an example of how this can work,the new state pension from April 2016 will be £8,093.80 a year. A pension pot of £110,000 would generate a tax-free cash sum of £27,500, plus, an indexed annuity of around £2,900 a year. This provides an indexed income to absorb the personal allowance. The key message here is to have pension income in both of the names of a couple.
It is also important to note that, for higher earners, the personal allowance is reduced by £1 for every £2 of taxable income above £100,000. This means the allowance is £0 if taxable income is £122,000 or more.
The savings rate of tax
The savings rate of tax is 0 per cent and applies to savings income up to £5,000, providing total taxable income (including interest) is less than £16,000 a year. This is in addition to the personal savings allowance, combining to make a potential total of £17,000 tax-free income a year.
Personal savings allowance
A revolution in cash savings will see all cash accounts pay interest without tax deducted and a new personal savings allowance introduced, in addition to the personal allowance. Basic-rate taxpayers will be able to receive £1,000 of interest from cash deposits without paying tax. Higher-rate taxpayers will be able to receive £500 of interest, while additional-rate taxpayers will not have a personal savings allowance.
Other sorts of interest which can be included within the personal savings allowance are: interest from cash and deposit accounts; income from purchased lifetime annuities; gains from insurance bonds and endowments; interest from gilts and other fixed interest securities, including funds (those which are currently paying income with tax deduction are expected to convert to gross paying); and income from peer-to-peer (P2P) investments. This last example matches lenders to borrowers with the aim of providing better rates of return than cash as an investment. The income from P2P loans is also interest falling within the personal savings allowance. Interest is already paid gross but is taxable. There is an intention to deduct a withholding tax from April 2017, although this would seem less necessary now.
Dividend allowance
New rules applying to dividend income from shares mean that everyone can receive £5,000 a year of dividends tax-free. The dividend allowance is in addition to the personal allowance and personal savings allowance, potentially combining to £17,000 a year, or £34,000 for a couple.
Assuming a 3.5 per cent income yield, this means an investor with a share portfolio of £140,000 would pay no tax on the dividends received. For a 1 per cent yield the portfolio is £500,000 so there is some sense in holding higher yielding investments within an Isa.
The dividend allowance will absorb part of a tax band. An example of how this works is outlined in Box 1.
Isas
The interest from Cash Isas remains tax-free and the allowance for 2016/17 is unchanged at £15,240. The dividend income from stocks-and-shares Isas will be entirely tax-free.
National Savings & Investments (NS&I) products The most common NS&I products are fixed interest and index-linked savings certificates, as well as children’s bonds, and premium bonds.
Certain NS&I investments will pay tax-free returns. You can check which, and their availability, at www.nsandi.com.
Purchased life annuities
A purchased life annuity is an investment designed to provide a guaranteed income for life or over a fixed term, in exchange for a capital sum. Part of the income paid is deemed to be a return of the original investment and is tax-free. The interest element of the income is taxable, but no tax will have to be paid on it if it falls within the personal allowance or personal savings allowance.
Venture capital trusts
Income from venture capital trusts (VCTs) is tax-free and income tax relief is also available on new subscriptions, up to a maximum of 30 per cent of the amount invested, for example £3,000 on a £10,000 investment, capped at a £200,000 investment. Investors have to hold the VCT for five years to retain the tax relief.
As the relief is given as a reduction from the investor’s tax bill, the investor must pay sufficient tax to take advantage of the tax relief.
VCTs are also capital gains tax (CGT) free.
Long term care annuities
Long-term nursing care is expensive; average costs exceed £600 a week. One of the most tax-efficient ways to help pay for care is to use a long term care annuity. This is designed to pay high rates of income to help meet care costs and the income is tax-free if paid direct to the care provider.
State benefits
Certain state benefits, such as child benefit, attendance allowance, and disability living allowance are paid free of tax. For example child benefit is worth £20.70 per week tax-free for the first child and £13.70 for subsequent children (2015/16 and 2016/17 rates).
However, families where the highest earning parent has a net adjusted income of £50,000 or more will be taxed by 1 per cent of the child benefit for every £100 excess income until the benefit is completely eradicated at £60,000 income.
Capital gains tax allowance
Although not strictly speaking income, investors can realise capital gains of up to £11,100 (2015/16 exempt amount) per tax year free of CGT. Some investors use their CGT allowance annually to supplement their income. Alternatively, Bed & Isa moves existing taxable investments into Isa to use the CGT allowance.
Rent-a-room scheme
Renting a furnished room of your main residence will mean you receive up to £7,500 per year in rent tax-free. This is the equivalent of £9,375 before tax for a basic-rate taxpayer and £12,500 before tax for a higher-rate taxpayer.
Offshore investment bonds
Also technically not income, an offshore investment bond allows investors to withdraw 5 per cent of the original capital value each year for 20 years without immediate charge to income tax, for example £5,000 per annum from a £100,000 investment. Withdrawals in excess of this are subject to income tax at whatever rate of tax the investor pays, but could fall within the personal allowance, savings allowance or personal savings allowance.
Danny Cox is a chartered financial planner at Hargreaves Lansdown
