- Financial education
- 4 minute read
Ten years ago presenter Moira Stuart was a regular fixture on television, sitting in the broom cupboard of a suburban house and reminding us to submit our tax returns by the 31 January deadline. “Tax doesn’t have to be taxing”, we were reminded while waiting for the last, climactic part of Midsomer Murders.
While tax shouldn’t be taxing, it does require careful thought and planning. Using tax effectively - from making the most of the personal tax allowance every year through to getting tax right at retirement - is an essential element of financial wellbeing.
Tax planning is vital for every employee, regardless of their career stage or level of earnings:
Workers earning less than £100,000 per year have a full, personal tax-free earnings allowance of £12,570. That figure is for total earnings, so if employees have more than one job, keeping track of whether earnings are within this allowance can require careful management. There are also some other considerations that affect low earners – for example, while salary sacrifice can be a tax-efficient way of paying into a pension scheme, it must not push employee’s earnings below the national minimum wage.
Everyone can save up to £20,000 tax-free in the 2021/ 22 financial year using ISAs. This can be in a combination of cash, stocks and shares, innovative finance, help to buy (help to buy ISAs are no longer available to new applicants, the scheme closed on 30 November 2019) or lifetime ISAs. This offers huge flexibility for all employees to save tax-efficiently. However, with such a wide range of ISA products now available, it can be difficult for individuals to know what will best suit their needs.
Financial education has a huge part to play in helping employees to understand the ISAs on offer, how best to combine them, and selecting the right product for their needs.
For many investors, using a stocks and shares ISA offers a very effective way of investing tax-free, up to £20,000. Profits from share price increases, interest on bonds and dividend income are all exempt from tax. However, dividend income outside a stocks and shares ISA also offers a £2,000 tax-free allowance, which may be a consideration for some larger-scale investors.
The range of stocks and shares ISAs is now very wide, ranging from straightforward ‘index tracker’ funds that mirror the performance of an index such as the FTSE 100, to products where individuals can create their own fund range. Many are managed online and are easy to set up. But making sure employees choose a product that matches their appetite for risk and their ability to manage the fund, requires financial guidance or advice. And, tax-free doesn’t mean fee-free. Some stocks and shares ISAs include substantial charges which employees will also need to understand before investing.
The most obvious way of saving tax-efficiently for retirement is in a pension. Employees can save up to 100% of their income, or £40,000 per year (the ‘annual allowance’) into a pension and receive income tax relief at their highest marginal rate of tax. That includes employer and employee contributions, along with any tax relief received.
For higher earners, there are some other important considerations. Above the £40,000 annual allowance, pension contributions are added to other income and taxed accordingly. Employees earning over £150,000 have a ‘tapered’ annual allowance, meaning that the allowance will reduce by £1 for every £2 that income exceeds £150,000. For someone earning £210,000 per year, this means their annual allowance is reduced to £10,000.
Another consideration is the Lifetime Allowance which is currently £1,073,100. While that sounds like an unimaginable sum to many, more and more individuals will breach this limit during their working life. If employees have saved over this limit, they will be charged 55% tax on the excess if they take pension savings as a lump sum with no further tax to pay or, 25% if they take it as income which would then be subject to income tax.
Helping high (and even mid-) earners to save tax-efficiently if they have reached their annual or lifetime allowance can make a substantial difference to an individual’s wealth in retirement – and how they save for retirement during their working life.
When employees reach the age of 55 (age 57 from 2028), they can start to withdraw money from their pension savings. We’ll explore this area in more depth in the final part of our Seven Steps to Financial Wellness series – but there are some major tax considerations around when and how employees take money from their pension. Once an employee starts to withdraw taxable money, their annual allowance falls to £4,000 per year (called the Money Purchase Annual Allowance - MPAA). Any contributions above this level are subject to tax. Withdrawing a lump sum from a pension pot can also have serious tax implications if it pushes an individual’s income for a given year into a higher tax bracket. However, an employee could potentially access their tax-free Pension Commencement Lump Sum (PCLS), which is typically up to 25% of the total fund value, without triggering the MPAA, or impacting upon their income tax position.
Managing tax effectively is the glue that binds together many of the other stages in the Seven Steps to Financial Wellness. From building good savings habits and investing effectively through to retirement planning, it’s essential to plan ahead, so that it will never become taxing.