What to do when frozen thresholds put you in a higher tax bracket

The freeze on income tax thresholds and changes to dividend and CGT allowances will see millions dragged into higher rates of taxation, but there are ways for higher earners to reduce their tax bill.

A consequence of frozen thresholds combined with rising wages means that the stealth tax increase will see many households pay thousands more in tax than they would have done had thresholds been indexed in line with inflation.

The Office of Budget Responsibility (OBR) estimates that by 2028-29 the deep freeze on tax thresholds will see around four million extra taxpayers while three million more will have moved to the 40% higher rate of income tax, and another 400,000 will pay the additional 45% rate.

For those who find their income tax bill rising thanks to frozen thresholds, here is a checklist of actions to take:

Cancel marriage allowance (£12,570)

When you become a basic rate taxpayer you lose the ability to claim the marriage allowance. The marriage allowance is a tax break offered by the government to married couples or those in a civil partnership and is worth up to £252 a year.

To claim it one half of the couple must be a basic rate taxpayer, which means they earn £50,270 or less a year in the current tax year, and the other half of the couple must earn less than the personal allowance, which is £12,570.

This means that once the higher earner crosses the £50,270 earnings threshold, they will no longer be eligible for the tax break.

Similarly, if the lower earning partner finds their income exceeds the personal allowance it means they will no longer be able to share it with their spouse via the marriage allowance.

Action: The person who made the claim for marriage allowance must cancel it, using their Government Gateway ID to process the cancellation.

If you can afford it, diverting some of your salary into a pension to remain below the higher rate tax threshold or personal allowance threshold (for the higher and lower earner respectively) would allow you to continue using the marriage allowance.

Repay child benefit (between £50,000 and £60,000)

Once parents start earning more than £50,000, they are subject to the Child Benefit High Income Charge. This means they lose 1% of their child benefit payments for every £100 they earn over £50,000.

If you had two children, you would be entitled to £2,074.80 a year in child benefit in the current tax year.

For someone with children a £1,000 pay rise equals a 10% loss in child benefit, which equates to £207. Frustratingly you cannot just claim the exact percentage of the benefit amount you are entitled to. Instead, you have to be paid the full child benefit and then the government reclaims half of it by charging you at the end of the tax year.

Action: Tell HMRC as soon as you realise you will face the High-Income Charge. The person in the couple with the highest income will be responsible for paying the tax charge, or they can choose to opt out altogether.

If you choose to receive the benefit and pay the tax charge you will need to fill out a self-assessment tax return and then pay what you owe.

Alternatively, the higher earner could try to reduce their income below the £50,000 threshold by making pension contributions.

Claim 40% pension tax relief (higher rate, £50,270)

Once you hit the higher rate income tax band you will be eligible for more tax relief on your pension – but often people are not aware that they need to claim it.

It depends on the type of pension scheme you are in – if you make personal contributions to ‘relief at source’ schemes you will need to claim the additional tax relief back from HMRC. Many workplace pensions operate this way.

This might feel like a real admin headache, but you could easily reclaim hundreds, or even thousands of pounds, owed to you in unclaimed tax relief, especially if you were a higher rate taxpayer already and can backdate the claim.

Action: If you are in a relief at source scheme you will need to file a tax return to claim your additional tax relief. This money will be paid out to you or offset against your tax bill. You can also claim via the Government Gateway.

Claims can be backdated up to four years, so if you realise you should have been claiming in previous years as well, make sure to get your claim in ASAP, before the current tax year ends.

If you aren’t sure what type of pension scheme you are in and what tax relief is receives automatically then call and ask them.

Prepare for reduced savings allowance (higher rate, £50,270)

Once you hit the higher rate income tax threshold the amount you can earn in savings interest before paying tax is slashed in half.

Basic rate taxpayers have a £1,000 limit but once you hit the higher rate tax band you will see that cut in half to £500. It could land you with an extra tax bill of up to £200.

Action: Move your money into an ISA, so that you do not get taxed on any savings income. Sometimes ISAs will pay a lower interest rate, but for higher rate taxpayers that will often be balanced out by the fact that you do not have to pay tax on the money.

Prepare for higher capital gains tax and dividend rate (higher rate, £50,270)

Once you hit the higher rate of income tax you will pay a higher rate of dividend tax and capital gains tax (CGT). Anyone with dividends over the current £1,000 annual tax-free limit will go from paying 8.75% tax on dividends to 33.75%.

It is the same case for those with capital gains, who will go from paying 10% tax to 20% tax on their gains over the tax-free limit.

It is an even bigger tax rate on any gains made from second properties, with the rate going from 18% up to 28% once you hit the higher rate of tax.

The tax-free allowance is also falling for both CGT and dividends, making the impact even worse.

Action: Be aware of whether you are likely to hit the higher rate threshold before you cash in on capital gains – if your income is temporarily higher this year you could delay the gain until the next tax year and pay a lower rate of tax.

Alternatively, you might want to conduct a ‘Bed & ISA’ transaction now, where you sell assets outside an ISA and the re-purchase them inside the tax wrapper. It often makes sense to do this anyway if you have unused CGT allowance, regardless of your tax band.

If you have dividends from investments outside an ISA or pension, look at whether you can transfer them into a tax efficient account, so you do not pay tax on those dividends.

Tax free childcare and additional free hours (£100,000)

Once you or your partner hit earnings of more than £100,000 you will no longer be eligible for tax-free childcare or the full free hours entitlement.

That includes the extended childcare offering being introduced by government, with free hours entitled being phased in for children as young as nine months old.

Action: You’ll need to stop claiming the tax-free childcare through your Government Gateway account and also cancel the 30 hours free.

You will still be eligible for 15 hours of free childcare, but this is claimed by your nursery or childminder on your behalf.

This is a sizeable loss of cash and because the cut off is an immediate ‘cliff edge,’ a pay rise taking you slightly above £100,000 can actually leave you worse off.

Combined with the impact of the personal allowance taper (below), it is often better to divert money into your pension to keep your taxable earnings in five figures.

Prepare for personal allowance taper (£100,000)

Once you hit more than £100,000 of earnings you start to lose your tax-free personal allowance at a rate of £1 for every £2 you earn over the limit.

It means the entire personal allowance is wiped out once you hit £125,140 of earnings.

Because of this, in this band of earnings you will effectively be paying a very high rate of income tax on the money – 60%.

Action: It can be very tax efficient to pay money into your pension instead. Once you factor in pension tax relief and any employer matching, you can often make a sizeable pension contribution with very little impact on your pay after tax and childcare costs. In some cases, you may even have more money left over.

Prepare for losing personal savings allowance (additional rate, £125,140)

Once you hit the additional rate of income tax you will lose any tax-free allowance for your savings income. While basic rate taxpayers get £1,000 tax free and higher rate taxpayers get £500, an additional rate pay gets no tax-free limit. It means that you will pay 45% tax on any savings income you receive.

Action: Moving your money to a tax-efficient account like an ISA or an NS&I account means you will not have to pay tax on any savings interest.

If you can bring your income below the additional rate band, by putting money in your pension or giving to charity, you will benefit from the £500 personal savings allowance given to higher rate taxpayers.

Prepare for higher dividend rate (additional rate, £125,140)

Once you hit the additional rate of income tax you will pay a higher rate of dividend tax.

Anyone with dividends over the current £1,000 annual tax-free limit will go from paying 33.75% tax on dividends to 39.35%.

For someone with £500 of dividends over the tax-free limit that means an extra £28 in tax a year.

What’s more, if you are near the additional rate threshold or have significant dividend income you could find that your dividend income pushes you into the additional rate threshold.

Action: As before, if you have dividends from investments outside an ISA or pension and still have some of your annual allowances for those accounts remaining, look at whether you can transfer them into a tax efficient account, so you do not pay tax on those dividends.

Move the investments that generate the highest income into your ISA first, so you have protected as much money from tax as possible.

Laura Suter – AJ Bell – Accountancy Daily

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