Top 3 tax allowances to maximise - are you making the most of them?

In our first blog post on tax year-end planning, we looked at the biggest source of tax relief: pensions tax relief.

However, if you’ve maxed out your pensions annual allowance – or you’ve put all you’re prepared to save into a pension this year – but still want to make the best use of your capital before the tax year is up, then read on. There are plenty of other ways to save on tax, thanks to the various allowances granted to us by HMRC.

Are you making full use of them? Below is a list of the top three allowances to look out for:

The ISA allowance

Your adviser may talk about this allowance a lot come February and March time and for good reason. All savings held inside a cash or stocks and shares ISA are exempt from capital gains tax (CGT), dividend tax and income tax – and you’re allowed to put up to £20,000 a year into this tax-shielded environment.

Still unsure? Here are three more reasons why loading up your ISA is a great idea:

ISAs are a great source of retirement income

Come retirement, it’s hugely beneficial to have a healthy ISA to draw an income from before you touch your pension. That’s because personal pensions sit outside your estate for inheritance tax purposes, so are easier to pass onto the next generation (NB: this excludes defined benefit and occupational pensions, which tend to lapse when you die, with the possible exception of a reduced spouse’s pension).

Compound interest will amplify your tax savings

The effects of compounding are augmented when they’re not weighed down by taxes. Just as platform fees can eat into long-term investment returns, so can dividend taxes, CGT bills and income taxes. That’s why GIAs – or ‘General Investment Accounts’ – should only ever be used as ‘overspill’ for when you’ve maxed out your ISA. It’s also why your financial adviser may recommend an annual ‘Bed & ISA’ transaction, where money held in less tax-efficient environments is transferred to your ISA each year, to ensure you’re making full use of your entitlements.

Married couples can further benefit from the perks of ISA investing

If you’re married, that’s two ISA allowances you’ve got to play with. Transfers between spouses are tax-free, so if one of you is nearing the subscription limit, there’s always the opportunity to divert investment contributions to your spouse’s ISA to gain the greatest tax benefit.

The personal savings allowance (PSA)

Once your ISA(s) have been tended to, your next port of call is the personal savings allowance (PSA). It’s worth knowing about, as it could affect the amount you decide to hold on deposit for easy-access savings.

If you’re a basic rate taxpayer, you can receive up to £1,000 in savings interest per year free of income tax. However, this reduces to £500 if you’re a higher rate taxpayer. Additional rate taxpayers lose their entitlement completely. Not only that, but the interest is no longer automatically deducted at the basic rate. Therefore, savings interest income that exceeds your PSA needs to be declared on your self-assessment tax return – so don’t get caught out.

Could you qualify for the starting rate band?

If you’re a stay-at-home parent or otherwise don’t earn an income which is subject to income tax, you could qualify for the ‘starting rate band’. This will prove useful if you’ve got a large amount of capital in savings generating interest, but no employment income.

In effect, it means that you can earn tax-free interest on savings up to the personal allowance (currently £11,850 in 2018/19, and rising to £12,500 in 2019/20), plus the £1,000 personal savings allowance, plus another £5,000. Thus, if you get by solely on income generated by cash savings, you’re allowed to earn up to £17,850 tax-free in 2018/19 (£18,500 in 2019/20).

The dividend tax allowance

Dividends are paid to shareholders out of company profits, and they attract a lower rate of tax than earned income. As a result, the threshold at which you start paying tax on dividend income is much lower than for ordinary income, currently at £2,000 (down from £5,000 in 2017/18).

The next £32,500 of dividend income is taxed at a basic rate of 7.5% (although your tax-free dividend allowance can be augmented by any unused personal allowance you may have). The next £115,000 of dividend income falls into the higher-rate band and is taxed at 32.5%. Finally, once all other allowances and bands have been utilised, additional dividend income is taxed at 38.1%.

Often, because of the more favourable tax treatment of dividends, many company directors take a small salary up to the personal allowance threshold and receive the rest of their income in the form of dividends. If this is what you do, then there’s one more pension tax relief opportunity open to you we haven’t previously mentioned…

As we explained in our last blog, when you make a pension contribution, the gross amount gets subtracted from the income used to calculate the rate of tax you pay. Therefore, if you can contribute an amount to your pension that takes you out of the higher rate band (32.5%) and into the lower rate band (7.5%), then not only will your contribution attract basic rate tax relief at 20%, you will also be spared paying an extra 25% in dividend tax on top (i.e., 32.5% minus 7.5%). That’s an effective rate of tax relief of 45%.

Want to read more about the capital gains tax annual allowance and investment property allowances? Look out for our next blog, where we’ll delve into these topics in the context of tax year-end planning.

The suitability of investments is based upon personal circumstances and you should seek professional advice before taking any course of action.

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