Tax Band Changes – Winners and Losers

March 3rd, 2008

With effect from 6 April 2008, there will be some important changes to the tax bands that could impact not only on the amount of tax you pay but also on your pension planning. The main changes that could affect you are:

  • The 10% starting rate of income tax will be withdrawn for earned and pension income and the basic rate of income tax will be cut from 22% to 20%, thus creating a simpler structure of two income tax rates: a 20% basic rate and a 40% higher rate.
  • The personal allowance – the amount of income you can earn before you start to pay any income tax, will increase from £5,225 to £5,435 for those aged under 65.
  • The higher personal allowance available to someone aged between 65 and 74 will increase from £7,550 to £9,030 and the personal allowance available to someone aged 75 or over will increase from £7,690 to £9,180. The Chancellor expects 580,000 more pensioners will no longer have to pay any income tax due to these increases to the age related allowances.

The impact of the income tax changes

Whilst the significant increase in the higher personal allowance for those aged 65 or over will clearly be beneficial to older people, the removal of the 10% starting rate of tax will increase the amount of income tax payable for those on earned and pension incomes of approx. £18,500 or less.

For example, if the current 10% rate on the first £2,230 of income over and above the personal allowance was to remain, the income tax liability for someone aged under 65 with a normal personal allowance of £5,435 in 2008/09 and earned income of £10,000 would be £223 on the first £2,230 of taxable income and £513 on the balance – a total of £736. With the removal of the 10% rate and the reduction of the basic rate to 20%, this would increase to £913.

On the other hand of course, people earning more than approx. £18,500 will see their income tax liability reduced.
Apart from the obvious impact on the amount of income tax we pay, the knock-on effect for contributions made to pension schemes operating tax relief under the ‘relief at source’ method such as personal pensions and stakeholders will be a reduction in the gross amount paid into the scheme (assuming no adjustment is made to the net payment), because the corresponding tax relief on the net contribution will fall from 22% to 20%.

This means that whilst a net contribution to a personal pension in March 2008 of £7,800 will equate to a gross contribution of £10,000 (£7,800 / 0.78), the same net contribution of £7,800 made in May 2008 would be grossed up to £9,750 (£7,800 / 0.80) i.e. £250 less.

If you are making contributions into a personal pension or stakeholder the actual contribution made will therefore need to increase if the gross amount is to remain the same (although it may be the case that your provider will increase the net payment automatically – you should check with your provider to see if this is the case), and if you are a higher rate taxpayer you will be able to claim the additional 20% tax relief (as opposed to the current 18%) through your self assessment tax return.

Levels and bases of and relief’s from taxation are subject to change and their value depends on the individual circumstances of the investor.

The Financial Services Authority does not regulate taxation advice.