How To Protect Your Income From The Taxman

Income and tax

Tax on your investment and savings is an important consideration. There are several

tax-advantaged schemes designed to encourage people to save, such as ISAs and pensions. It is always worthwhile considering these when making any investment decisions. It is expected that tax rates will rise over the coming years in the UK. If you choose to invest via a tax efficient wrapper such as an ISA or a pension, there are specific tax advantages available on your income.

ISA

The annual ISA allowance 2011 for everyone over 18 is £10,200 – making a total of £20,400 for a couple. ISA limits will also increase annually in line with inflation. You will not have to pay any capital gains tax on the investment growth nor will you have to pay any tax on any income payments. It’s also worth bearing in mind that you do not have to include ISAs on your tax return, which can

save a great deal of time and paperwork.

The eligibility to invest in an ISA or pension and how much the tax savings are worth depends on individual circumstances and all tax rules may change in the future.

Share dividend income:

If you are a basic rate taxpayer, whether inside or outside an ISA, you do not have to pay any personal income tax on dividend income. Dividends payments are generally accompanied by a 10% ‘tax credit’ but this cannot be reclaimed for ISA investments.

If you are a higher rate or additional rate taxpayer, you do not have to pay any personal income tax on dividend income within an ISA. You will normally have to pay tax on dividends payments outside

an ISA. The current rates of personal tax on dividends are 32.5% for a higher rate taxpayer and 42.5% for an additional rate taxpayer. Because the attaching 10% ‘tax credit’ is taken into account it means that a higher rate taxpayer pays 25% tax on the dividend they receive and an additional rate taxpayer pays 36.11% on the dividend they receive.

For bonds and cash:

You will not have to pay any income tax on interest paid by these funds inside an ISA. Outside of an ISA the interest will normally be paid net of basic rate tax (20%), which is deducted at source. Higher rate taxpayers will normally have to pay an additional 20% tax on the gross interest amount and additional rate taxpayers an additional 30%.

Pensions

You pay income tax on your earnings before any personal pension contributions, but the pension provider claims back tax from the government at the basic rate of 20%. This means that for every £80 you pay into your pension, you end up with £100 in your pension pot.

If you are a higher-rate taxpayer you can often reclaim a further 20% so that £60 buys £100 into your pension pot (there are however some restrictions on tax-relief for people on high income, which were introduced in 2009). If this is not done for you, you must claim the difference through your Self Assessment tax return making a claim to HM Revenue & Customs (HMRC). Any income you receive from your pension after you retire is taxed at prevailing income tax rates.

Capital Gains Tax

Capital Gains Tax (CGT) is a tax on the gain or profit you make when you sell, give away or otherwise dispose of something that you own, such as investments. There is an annual tax-free allowance, which is currently £10,100 (2010/11) and will be index-linked in future years. If your overall

gains are below the annual allowance, you will not pay capital gains tax. If your overall gains for the tax year are above the annual allowance, you will pay capital gains tax on the excess. The rates of capital gains tax for individuals are 18% and 28% and the rate used will depend on the amount of

your total taxable income and gains. The annual allowance can be particularly useful when investments that have produced capital growth are cashed in to create an effective ‘income’.

If you have a private pension or company pension you are likely to have some decisions to make when you retire. You will be asked whether you would like to take a cash lump sum and what you would like to do with the remaining pot. Here are two of the more common options.

Annuities

The new coalition government is currently reviewing the effective requirement for most retirees to buy an annuity by a certain age. Further details are expected to emerge in 2011, in the meantime the age limit at which the annuity must effectively be purchased has been increased from age 75 to age 77, for persons who reach the age of 75 on or after 22 June 2010.

Annuities provide a guaranteed income for life in return for the purchase price. An annuity is an insurance policy rather than a direct investment so the provider you select will be investing your money behind the scenes while paying your yield in accordance with the annuity contract. Some annuities will increase to keep up with inflation; others will pay a level amount throughout.

You cannot change your mind and switch annuity providers so it's vital to do research into your annuity options and you may wish to seek some financial advice.

Income drawdown from your pension

Income drawdown is a flexible retirement option that is usually available from your retirement date up to a certain age when for most people there becomes an effective requirement to buy an annuity. It allows you to make investments with your pension pot rather than make an immediate annuity purchase. Because of this, you can tailor your retirement assets to your investment preferences. There are risks and drawbacks in this so you should seek financial advice before considering drawdown and remember that the new government might change the rules surrounding private pension arrangements after its review. With most pension products you can start to draw benefits from 55.

Drawing an income

How you take your income is also a consideration when deciding which investments to make. Do you need the money monthly, quarterly or as and when required? Income funds will pay their income on regular cycles so you can match these to your needs.

Regular withdrawal plans

Many investment companies, understanding the need for you to take an income, offer regular withdrawal facilities. They work by paying a specified amount from your investment accounts and transferring the money directly to your bank account. If the yield on your investments is not sufficient to pay you the amount you decide you need, the withdrawal facility will sell investments

to make up the difference. This way you know you will have a regular income come

what may. Remember, however, that this may reduce the capital over time if the fund’s growth does not compensate for the withdrawals.