Niki Patel examines tax year-end planning opportunities
Now is a good time to engage with your clients to ensure they have taken advantage of any tax year-end planning opportunities available to them. Each individual’s circumstances will differ, so the options available to them will undoubtedly vary depending on the assets and investments they own, together with ensuring their overall planning objectives are met.
It is, however, important to note that maximising use of allowances, exemptions and reliefs is at the forefront of any tax planning, especially because some of these may be lost if unused before the start of the new tax year.
In this article, I provide a general overview of some of the planning options available, which can be explored with your clients.
Most individuals are entitled to a personal allowance (PA), personal savings allowance (PSA) and dividend allowance. For the 2021/2022 tax year, the PA is £12,570, the PSA is £1,000 for basic-rate taxpayers and £500 for higher-rate taxpayers, and the dividend allowance is £2,000. It goes without saying that maximum advantage should be taken of using each of these allowances where possible.
The PA of £12,570 for 2021/2022 is reduced by £1 for every £2 where an individual’s adjusted net income exceeds £100,000 (broadly, income after deductions for pension contributions made gross, the grossed up value of any relief at source pension contributions and any charitable donations made by Gift Aid). This means that once income exceeds £125,140 it is totally lost. Income that causes the loss of the PA is effectively taxed at 60% (non-dividend income).
Tamira has earnings of £122,500 in 2021/2022. This means that without any planning, her PA would be reduced to £1,320.
This is calculated as follows:
£122,500 - £100,000 = £22,500
£12,570 - £11,250 = £1,320
Her income tax liability would therefore be as follows:
Less PA (£1,320)
£37,700 x 20% £7,540
£83,480 x 40% £33,392
If she were to make a gross personal pension contribution of £22,500 (£18,000 net) this would mean that her adjusted net income would reduce to £100,000, so she would benefit from a full PA and in addition the basic-rate threshold would be extended from £37,700 to £60,200, providing her with higher-rate tax relief on the contribution.
Less PA (£12,570)
£60,200 x 20% £12,040
£49,730 x 40% £19,892
The difference of £9,000 (i.e. £40,932 - £31,932) simply illustrates the further 20% tax saving on the pension contribution (£22,500 x 20% = £4,500), plus the higher-rate tax saving on retaining the lost PA (£11,250 x 40% = £4,500).
Therefore, the total tax relief on the £22,500 contribution is £13,500, an effective rate of 60%.
Other planning strategies would include the following:
- All individuals should seek to use their PSA and dividend allowance to maximise tax-free income.
- Consider reducing taxable income below £150,000 to avoid 45% tax. Pension contributions are one of the few ways to reduce taxable income and, following the increases in thresholds for taper relief from 6 April 2020, more high earners may be able to take advantage of this.
- Reinvest in tax-free investments, such as ISAs, to replace taxable income and gains with tax-free income and gains, or investment bonds that can benefit from valuable tax deferment.
- Couples (whether married or in a civil partnership) should consider making full use of their PA. Remember it is possible to transfer up to 10% of the PA from one spouse/civil partner to the other, provided neither spouse/civil partner is a higher or additional-rate taxpayer. The maximum that can be transferred for the 2021/2022 tax year is £1,260, which means couples can reduce the income tax they pay by up to £252 (i.e. £1,260 x 20%).
- Consider redistributing investments between couples to potentially reduce the rate of tax suffered on income and gains. No income tax or capital gains tax (CGT) liability will arise on transfers between married couples or civil partners living together, or where the asset to be transferred is an investment bond. However, any transfer must be made on an outright and unconditional basis with ‘no strings attached’. This effectively means investments must be fully transferred with no entitlement retained by the transferor.
- Where possible, couples should try to ensure that they both have adequate pension plans in place to provide them with an income stream in retirement, which will enable them to use their PA.
Capital Gains Tax
The annual CGT exemption is £12,300 for the 2021/2022 tax year and will remain at this level until 2025/2026. From a tax-efficiency perspective, where possible individuals ought to use the annual exemption (AE) each tax year as, if unused, it cannot be carried forward. The AE is deducted before determining how much of the capital gain is taxable.
The rate of CGT payable will depend on the individual’s other taxable income. Gains falling within the basic-rate tax band are taxed at 10% and any amount falling above that will be taxed at 20%. This means that use of the AE in 2021/2022 can save up to £1,230 for a basic-rate taxpayer and £2,460 for a higher/additional-rate taxpayer.
Gains incurred on residential property that are not covered by the private residence exemption are taxed at 18% for a basic-rate taxpayer and 28% for a higher/additional-rate taxpayer.
Again, a planning option could be to make a pension contribution to a registered pension scheme to extend the basic-rate band, which is also effective in saving CGT.
Clara has earned income of £51,500 in the 2021/2022 tax year. She also realised part of her unit trust portfolio, which gave rise to a capital gain of £26,270. The basic-rate threshold for this year is £50,270 (including the PA of £12,570), which would mean some of her income would be taxed at 40% and any taxable capital gain would be taxed at 20%.
To reduce her tax bill, Clara could consider making a gross personal pension contribution of £15,200 (£12,160 net). For income tax purposes, this will increase her basic-rate tax band from £37,700 to *£52,900 (and her basic-rate threshold from £50,270 to £65,470). This would mean that all of her income is taxed at 20%, so she would benefit from some higher-rate relief and her taxable capital gain is taxed at 10%.
Earned income £51,500
Less PA (£12,570)
Taxable capital gain
Less AE (£12,300)
Other planning strategies would include the following:
- While it is advisable to use the CGT AE, it is not possible to crystallise a capital gain by selling and then immediately repurchasing an investment – i.e. the so-called ‘bed-and-breakfast’ rules – as the seller must not personally reacquire the same investment within 30 days of disposal. However, there are other ways of achieving similar results:
- Bed-and-ISA. An investment can be sold, e.g. shares in an OEIC, and bought back immediately within an ISA. For 2021/2022, the maximum ISA subscription limit is £20,000.
- Bed-and-SIPP. Here the cash realised on sale of the investment is used to make a tax relieved contribution to a self-invested personal pension (SIPP), which then reinvests in the original investment. This approach may also offer a higher reinvestment ceiling than an ISA, depending on a person’s earned income and other pension contributions.
- Bed-and-spouse. One spouse/civil partner can sell an investment and the other spouse/civil partner can separately buy the same investment without falling foul of the rules against bed-and-breakfasting.
- Bed-and-something similar. This involves the sale of shares in one fund with a purchase in a similar fund.
- Making use of losses. Current-year losses must be deducted from capital gains of the same tax year, before deducting the CGT annual exempt amount. However, where the loss is a carried-forward loss, the taxpayer need only use so much of the loss that reduces the taxable gain by an amount that leaves the CGT AE amount intact. Any balance of losses can be carried forward. Using losses in this way can therefore be tax efficient, particularly for those who are higher/additional-rate taxpayers and so pay CGT at 20% (or 28%).
- Where someone is considering making a disposal now that will trigger a capital gain in excess of £12,300 (2021/2022), it may be worth spreading the disposal across two tax years if possible, to use two years of AEs.
- A spouse/civil partner could make an outright and unconditional transfer (as mentioned above) of assets into their partner’s name to make use of their AE on subsequent disposal. This will mean that, between them, they can realise capital gains of £24,600 in 2021/2022. This should not generally give rise to any inheritance tax (IHT) consequences or CGT implications. Indeed, it may even be worthwhile transferring an asset showing a gain of more than £12,300 if the asset is to be sold, as it would mean the surplus capital gain is taxed at 10% rather than 20%.
The IHT nil rate band and residence nil rate band are frozen at £325,000 and £175,000 respectively until the 2025/2026 tax year. Remember that the residence nil rate band is tapered by £1 for every £2 where the total estate exceeds £2m, so clients ought to consider their own circumstances and consider whether they can carry out any planning to prevent any lost residence nil rate band.
From a general IHT planning perspective, much will depend on what assets the client has, however, as wealth continues to increase, planning to mitigate IHT should be considered as soon as possible, especially given that in many cases clients do not make full use of the exemptions available to them.
The primary starting point for anyone wishing to carry out IHT planning is to consider using their exemptions:
- Annual IHT exemption – each individual can give away £3,000 each tax year, and they can use the previous tax year’s exemption if not already used; but it must then be used after the £3,000 exemption for the current year.
- Small gifts exemption – up to £250 can be given to any number of individuals (note this exemption cannot be combined with any other exemption in favour of the same person).
- Gifts in consideration of marriage/civil partnership – £5,000 if the donor is a parent of one of the parties to the marriage/civil partnership, £2,500 if the donor is one of the parties to the marriage/civil partnership or a grandparent, and £1,000 for any other gift.
- Normal expenditure out of income – any gift is exempt from IHT if:
- It forms part of the donor’s normal expenditure
- Taking one year with another, it is made out of income
- It leaves the donor with sufficient income to maintain their usual standard of living.
- Unlimited gifts to registered charities, political parties or for national benefit.
Planning in this area is often overlooked, with few clients using these exemptions to the full potential – even though regular use of these exemptions over time can result in large IHT savings.
Over the past 30 years, Maria has always made use of her annual IHT exemption of £3,000 in favour of her son and she has also gifted £250 to each of her three grandchildren. In doing so, she has gifted £112,500 (£90,000 using the annual IHT exemption and £22,500 using the small gifts exemption), which has saved her £45,000 in IHT. So, using these exemptions – which may seem nominal to many – provides a good outcome for family members.
The tax year-end is also a good time to generally consider a client’s IHT position with a view to making larger gifts and, as mentioned above, those who wish to mitigate IHT should consider forward planning.
Other planning strategies would include the following:
- Clients could consider making outright gifts either directly to another individual or via an absolute trust. The gift will be a potentially exempt transfer for IHT and there is no limit on the amount which can be gifted. Provided the individual survives seven years from making the gift, it will generally fall out of account. If the gift does become chargeable, it will first use any available nil rate band and then taper relief may apply to reduce any IHT payable, provided the donor survived at least three years.
- In cases where clients wish to retain control and flexibility, they could consider setting up a discretionary trust. However, in order to ensure no lifetime IHT is payable, the client can only settle up to their available nil rate band, taking account of any chargeable lifetime transfers in the seven years prior to creating the trust. Remember that a discretionary trust is subject to the ‘relevant property regime’, so exit (when capital is appointed out of the trust) and periodic (10-year anniversary) charges apply. Although, in practice, with careful planning it is possible to mitigate these charges.
- There are also a number of other types of trusts that are widely available for IHT planning purposes, which can be used where the client may wish to retain access if they require, for example, a loan trust and a discounted gift and income trust. Advice should be sought to determine which (if any) of these options are likely to be suitable.
- While not directly related to tax year-end, those who have received an inheritance within the last two years could consider entering into a deed of variation, provided all of the relevant conditions are satisfied. Broadly, the variation must be made within two years of death, it must be in writing, it must contain a statement that section 142 of the Inheritance Tax Act 1984 applies, and it must not be for consideration.
Investing in a pension is a tax-efficient way of saving for retirement and also provides other tax benefits as illustrated above. Therefore, it is vital for clients to maximise pension contributions where possible.
Planning strategies would include the following:
- The carry-forward rules (see page 41 for more detail) allow unused annual allowances to be carried forward for a maximum of three tax years. Thus, 5 April 2022 is the last opportunity to use any unused allowance of up to £40,000 from 2018/2019.
- Those caught by the tapered annual allowance, with sufficient carry forward, may be able to make additional pension contributions to reinstate their full annual allowance for tax year 2021/2022, by reducing their threshold income to £20,000. This would mean more pension savings may be possible.
- Pension contributions can also help families recover their child benefit, which is progressively cut back if one parent or partner in the household has income of more than £50,000 in 2021/2022. Child benefit is totally lost when income reaches £60,000 in 2021/2022.
- Individuals could consider making a net pension contribution of up to £2,880 (£3,600 gross) each year for members of their family, including children and grandchildren, who do not have relevant UK earnings. The UK Government will add £720 basic-rate tax relief. Such payments would normally be gifts for IHT unless covered by an exemption.
For all clients it is important to consider making use of tax-efficient investments where possible.
The maximum annual ISA subscription limit is £20,000. This means a couple could, between them, invest £40,000. A child aged 16 or 17 can invest £20,000 in a cash ISA in 2021/2022.
While no tax relief applies on an ISA subscription, income and capital gains within the ISA are free of tax. This means that for those whose dividend income could exceed their dividend allowance of £2,000, tax freedom on dividend income within the ISA will save tax at 7.5%, 32.5% and/or 38.1% as appropriate.
Where a spouse/civil partner has died during the 2021/2022 tax year owning an ISA, it is advisable to check whether an additional ISA allowance exists.
Junior ISAs (JISAs)
Broadly speaking, JISAs are available to any UK resident child, under age 18, who does not have a Child Trust Fund (CTF) account. Any individual may contribute into a JISA on behalf of a child and the maximum subscription limit is £9,000 this tax year. Those aged 16 or 17 can also invest £20,000 per annum in an ISA. For those who have a CTF, it is still possible to subscribe up to £9,000 into the account.
Growth-oriented unit trusts/OEICs
Rates of income tax are higher than the current rates of CGT, so it can be advisable, from a tax perspective for a higher/additional-rate taxpayer, to invest in collectives geared towards capital growth as opposed to income. This would enable the individual to make use of their annual CGT exemption on a later encashment.
Single premium investment bonds
Bonds (onshore or offshore) are non-income-producing investments, so are useful investments to defer tax payable by use of the 5% cumulative allowance. This can be valuable for a higher/additional-rate taxpayer, especially where they are likely to become a lower-rate taxpayer in the future.
Enterprise Investment Scheme (EIS)
For tax year 2021/2022, an investment of up to £1m or £2m (provided anything above £1m is in knowledge-intensive companies) can be made to secure income tax relief at 30%, with tax relief being restricted to the amount of income tax otherwise payable by the investor in that tax year. The relief can be carried back to the previous tax year. In addition, unlimited CGT deferral relief is available, provided some of the EIS investment potentially qualifies for income tax relief, but investors considering deferral should remember that CGT rates may increase in the future.
Venture Capital Trust (VCT)
The VCT offers income tax relief for tax year 2021/2022 at 30% for an investment of up to £200,000 in new shares, with relief restricted to the amount of income tax otherwise payable by the investor in that year. Dividends and capital gains generated on amounts invested within the annual subscription limit are tax free, so again these investments may appeal to higher/additional-rate taxpayers. Because dividends from qualifying VCT investments are tax free, the 1.25% increase in dividend tax rates due to apply to dividends received on or after 6 April 2022, could make VCT investments more attractive.
As can be seen, there are numerous tax planning options that could be considered. However, approaching the end of the tax year is a good opportunity to ensure clients have maximised use of the allowances and exemptions available to them as discussed above. It is also a great time to fully review their overall financial planning needs to ensure they are on target to meet any short-term and long-term objectives ahead of the new tax year.
Niki Patel is a tax and trust specialist at Technical Connection.