As a new tax year approaches, it is a good idea to check whether tax allowances are being used to their full potential. Careful structuring of taxable investments can lead to significant tax savings.
Income tax
As a quick refresher, taxable income is ordinarily taxed in the following order:
- Non-savings income – such as earned, pension and rental income;
- Savings income – such as interest on bank accounts or from fixed interest paying investments;
- Dividend income;
- Gains on life insurance contracts.
For the 2019-20 tax year, an individual with taxable income under £50,000 will have the following allowances available to reduce their income tax liability:
- £12,500 personal allowance;
- £5,000 savings-rate band;
- £1,000 personal savings allowance;
- £2,000 dividend allowance;
- £1,000 property allowance;
- £1,000 trading allowance.
This adds up to a potential £22,500 tax-free income, without needing to take anything from Isas.
It’s important to remember that the savings-rate band, personal savings allowance and dividend allowances are actually nil-rate bands within the standard basic, higher and additional-rate tax bands.
The property and trading allowances are true ‘allowances’, in that income is not charged to income tax. In the above scenario, £8,000 of the basic-rate band has been used up by savings and dividend income, even though no income tax is actually payable.
Savings-rate band
This is a ‘window of opportunity’ for savings income of up to £5,000 where that income falls directly above the personal allowance. Assuming a standard personal allowance of £12,500, this means that any savings falling between £12,500 and £17,500 are potentially free of income tax.
Therefore, someone with earned or pension income equal to their personal allowance will have a £5,000 savings-rate band. However, if they had a £1,000 pay rise they would see their savings-rate band reduced to £4,000.
Personal savings allowance
A basic-rate taxpayer can receive £1,000 of savings free of income tax under this allowance. The PSA is reduced to £500 for higher-rate taxpayers and nil for additional-rate taxpayers.
Adjusted net income is used to determine whether someone is a basic, higher or additional-rate taxpayer. This means that the savings income itself may nudge adjusted net income into higher rates of tax. See Box 1 for an example.
Dividend allowance
Introduced in April 2016 at £5,000, this was reduced to £2,000 in April 2018. Dividends that fall within the personal allowance do not count towards the dividend allowance, but as mentioned above they will use up basic, higher and additional rate bands. See Box Two for an example.
Trading allowance
This is a £1,000 tax exemption to cover income received from ‘hobbies’; for example, occasional services such as babysitting or gardening, or ad-hoc online selling.
If total income from these sources is less than or equal to the full trading allowance, expenses are not deductible. For those receiving larger amounts of trading income, it is possible to elect for partial relief where the trading allowance is deducted from receipts, with no allowance for expenses. Alternatively, expenses can be deducted from receipts in the usual manner, with no trading allowance available.
Property allowance
This allowance is of most use to individuals receiving smaller amounts of rent from land they own. This might include those who rent out their homes on short-term lets on an ad-hoc basis, or small plots of land, garages and driveways.
The allowance is per person so, for example, a couple could earn £2,000 renting out their driveway.
If property income falls under the full property allowance, expenses are not deductible. Where property income in a tax year exceeds the £1,000 allowance, partial relief is available in the same manner as for the trading allowance, or the expenses basis can be used.
Be aware that the Rent-a-Room scheme is separate to property trading allowance and it is not possible to claim both. The scheme provides for up to £7,500 rental income per tax year exempt of income tax. It is available to resident landlords – so a room must be rented in the taxpayer’s main residence.
Rent-a-Room relief is per property not per individual, so a couple renting rooms to lodgers could receive £7,500 tax-free between them.
The advantages of claiming the Rent-a-Room exemption or the property allowance will depend on the individual circumstances such as gross rent received and allowable expenses.
Paying any tax due
Financial institutions will inform HMRC about interest paid to individuals. Where savings income exceeds the available allowances and the taxpayer is employed or receiving a pension, HMRC will reclaim the tax by adjusting their tax code.
If the taxpayer already completes a tax return or the savings income is £10,000 or more they should report it by self-assessment.
There is no need to report dividend income that falls within the dividend allowance. For dividend income up to £10,000 the taxpayer can ask HMRC to arrange payment, including changing their tax code. Otherwise, dividends should be reported on the self-assessment tax return.
Where income falls within the trading or property allowance there is no requirement to inform HMRC. Otherwise, the taxpayer should contact HMRC or register for self-assessment.
Planning opportunities
The sheer variety of income tax allowances available warrant the use of a diversified portfolio because of the range of investments required to maximise all the allowances.
On the downside, it is hard to match figures exactly, and attempting to do so may result in more work. For example, investing in property invariably means you are subject to maintenance and its associated costs and administrative burden.
Clearly, very few clients will hold the required range of assets in the correct proportions yielding the exact amounts required to fully use each allowance.
However, for those who have some control over their earned income, such as the self-employed and pensioners with lower levels of secure income but higher amounts of capital, a few small rearrangements can make a significant difference to their net income.
Victoria Harman is senior technical expert at Hargeaves Lansdown
