Don’t fall into the trap!

April 7th, 2008

If you are over (or indeed approaching) 65 then now may be a good time to check your finances to make sure you don’t end up paying too much tax, particularly as the income tax rates change from 6th April 2008.

You may be aware that the Chancellor announced in his pre-budget report in October that the basic rate of income tax will be cut from 22% to 20% from 6 April 2008 but, whilst this sounds great, he is also scrapping the 10% starting rate of tax for earned and pension income, which currently applies to the first £2,230 of income over the personal allowance. Whilst this may result in certain low-income households paying more tax (as highlighted in our previous article Tax Band Changes – Winners and Losers) the good news is, due to the personal income tax allowances for the over 65’s increasing by around 20%, that most people over this age should actually be better off as shown in the table below.

Gross income Net income (after tax) Change in net income (p.a)
2007/08 2008/09
£8,000 £7,955 £8,000 +£45
£10,000 £9,729 £9,806 +£77
£12,000 £11,289 £11,406 +£117
£15,000 £13,629 £13,806 +£177
£20,000 £17,529 £17,806 +£277

Note: This assumes all income is taxed as earned income, and the individual is aged 65-74

For those over 65 on higher incomes, however, it is still worth looking at your finances to see if you are inadvertently paying too much tax. As highlighted in the previous article, everyone receives a personal income tax allowance of £5,225 (increasing to £5,435 from 2008/09) but those over 65 receive an enhanced personal allowance or ‘age allowance.’ Although there are two rates, one for those aged between 65-74 and one for those aged 75+ both will increase by almost 20% next tax year.

For those with income over £20,900 (increasing to £21,800 for tax year 2008/09) the higher personal allowances are reduced back to the standard personal allowance by £1 for every £2 of taxable income exceeding this level. This not only includes earned income, but also income from personal/occupational pension schemes, interest on savings and investment income.

The table below shows how much additional tax you would pay as a result of this allowance being reduced (based on an individual aged between 65-74).

Gross taxable income 2008/09 Income over threshold (£21,800) Additional tax through reduction/loss of age allowance
£22,000 £200 £20
£25,000 £3,200 £320
£28,990+ £7,190+ £719

From next tax year (2008/09), for every £2 of income above the age allowance income threshold the effective rate of tax on that £2 is 30% (as the individual not only pays 20% income tax (£0.40) but the age allowance reducing by a £1 means that £1 of income which was previously tax-free is now also taxed at 20% (£0.20) = £0.60 tax on £2 = 30%). This is what is known as the “age allowance trap”.

If your total income exceeds the threshold you may be able to prevent losing your higher allowance. The key here is that it is an individual’s taxable income which is relevant in

assessing entitlement to a higher personal allowance and therefore there are various steps which can be taken to potentially alleviate or reduce this problem:

  • Using investments products which provide a tax-free income such as an ISA (Individual Savings Account) and certain National Savings Products.
  • Taking 5% tax deferred annual withdrawals from investment bonds, although partial or full encashments can cause problems
  • Using independent taxation – in other words transferring savings or investments (and therefore the income they generate) to a spouse.
  • Make contributions to a personal pension or stakeholder plan, which for the purpose of calculating the age allowance reduces your total income by the amount of the gross contribution made.
  • Make donations to charity under gift aid, which also reduces your total income by the amount of the gross contribution made.

It is essential to talk to your Financial Adviser with regard to the best way forward should you think that the above issues are relevant to you. Indeed, for married couples where one of the individuals was born before 6th April 1935 there may be the loss of the Married Couples Allowance to consider in addition.

The Financial Services Authority does not regulate taxation and trust advice and National Savings and Investment products. Levels and bases of and relief’s from taxation are subject to change and their value depends on the individual circumstances of the investor.