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Tax year end checklist: Ten things to consider before 5 April 2021

With just over two months to go until the end of the tax year, AJ Bell’s financial analyst Laith Khalaf outlines some important issues savers and investors should be considering to strengthen their financial position.

1. Use your Isa and pension annual allowances

Isas and pensions are a great way to save for the future because any income and capital gains made on investments held in both products are free from income tax and capital gains tax.

All adults can save a total of £20,000 each year in Isas, whether that be a cash Isa, Stocks and Shares Isa or a Lifetime Isa. Importantly, if you don’t use all the allowance, it can’t be carried forward, so you lose it for good. Investors with unused Isa allowance for this year should consider using it if they can before the 5 April deadline.

Things to do: February and March are a good time to get your tax affairs and finances in order.

The pension annual allowance for 2020/21 is £40,000 – this includes both contributions made by you and your employer. 

The annual allowance can be carried forward for up to three years, so investors should consider whether they have made as much use of their pension annual allowance as possible ahead of the end of the tax year.

Those with very high incomes or those who have started to take taxable income from drawdown will have a restricted annual allowance.

If you are looking to make use of carry forward, note that personal contributions in any year are also limited for tax relief to 100 per cent of your earnings. People with no earnings (including children) can still save up to £3,600 a year in a pension (including basic rate tax relief).

2. Ensure you benefit from free Government cash

A significant benefit of pensions and Lifetime Isas is that money you pay into them will benefit from a top up from the Government.

This is most generous in pensions, where personal contributions are automatically topped up by 20 per cent pension tax relief from the Government. That means that every 80p you pay into your pension is automatically topped up to £1. Higher rate and additional rate tax payers can reclaim an additional 20 per cent or 25 per cent tax relief respectively via their tax return. 

So, for a higher rate tax payer, every £1 that ends up in their pension only costs them 60p. Even with just basic rate tax relief, if you contribute £100 a month to a pension and assume 5 per cent investment growth each year, the Government contribution to your pension would be worth £38,000 after 40 years of saving.*

With the Lifetime Isa you can get up to £1,000 a year in the form of a Government bonus, up until the age of 50. If you opened a Lifetime Isa at age 18, that is a maximum Government bonus of £33,000 (or £32,000 if you’re unlucky enough to have your birthday on 6th April). 

The Lifetime Isa can be opened by those aged 18 up to the day before your 40th birthday, and you can save up to £4,000 each year – either in one or more lump sums or as a regular monthly saving. 

You can withdraw Lifetime Isa money once you’ve reached age 60 or earlier to buy your first property, but be warned that if you take the money for any other reason (apart from severe ill health) you’ll pay an exit penalty which is currently 20 per cent but is due to increase to 25 per cent on 5 April.

3. Work out which Isa is right for you

Isas are a simple savings product but there are a number of versions, which cater for different needs.

If you are saving for a house deposit, the Lifetime Isa is worth considering because it benefits from a 25 per cent Government bonus on up to £4,000 that can be paid in each year and a withdrawal for a first-time house purchase incurs no penalty. So that is up to £1,000 bonus each year and a Lifetime ISA can be held in cash or invested in stocks and shares.

If you are saving for a house deposit, the Lifetime Isa is worth considering, says Khalaf

If you are saving for a house deposit, the Lifetime Isa is worth considering, says Khalaf

If you are saving over the short term for something other than a house deposit, say within the next five years, then a Cash Isa could be the solution. However, with interest rates at historic lows, cash savings are likely to be eroded by inflation over the longer term.

Over the longer term, it is worth considering a stocks and shares Isa which offers access to a broad range of funds and shares, with the possibility of higher returns. If you assume investments return of 4.5 per cent** a year after charges, a £20,000 Isa pot would have grown to £31,059 after 10 years. 

Over the same period, a £20,000 investment in a Cash ISA earning the average interest rate of 0.35 per cent*** would have turned into just £20,711. After 20 years the difference between the two pots would be £26,787.

*Pension tax relief rates quoted apply in England, Wales and Northern Ireland, different rates apply in Scotland

**The 4.5% per annum investment growth used in this document is based on the inflation adjusted return from equities over the past 50 years of 5.3% taken from the 2020 Barclays Equity Gilt Study and taking off 0.8% for charges

***Source: Bank of England.

4. Don’t forget Bed and Isa

If you have investments held outside an Isa wrapper a Bed and Isa transaction is a simple way to open and fund a new Isa or top up an existing one. The investment outside of the Isa is sold, the proceeds moved into an Isa and used immediately to purchase the same investment within the Isa. 

Depending on which investment platform you use, the two transactions that make up a Bed and Isa may be counted as just one deal so you will only be charged one dealing charge.

Bed and Isa can be useful if you want to take advantage of the tax benefits in your Isa but don’t have readily available cash to invest and you do have investments held outside your Isa that you want to keep.

There may be a capital gains tax liability if the profit on the sale of the investment outside of the Isa exceed your annual CGT allowance of £12,300 in 2020/21 but once in the Isa all dividends and future capital growth are free from income or capital gains tax.

5. Put your dividend income investments in an Isa

Dividend income from investments held outside of an Isa or pension wrapper might be taxed.

You do not pay tax on any dividend income that falls within your Personal Allowance (the amount of income you can earn each year without paying tax). You also get a dividend allowance each year of £2,000. 

Dividend income from investments held outside of an Isa or pension wrapper might be taxed

Dividend income from investments held outside of an Isa or pension wrapper might be taxed

Any dividend income you get above this amount is taxed at 7.5 per cent for a basic-rate taxpayer, 32.5 per cent for a higher-rate taxpayer or 38.1 per cent for additional-rate taxpayers.

An investment pot of £100,000 that is yielding around 4 per cent as dividends would incur £150 a year in income tax outside an Isa if you are already a basic-rate taxpayer, £650 a year if you are a higher-rate taxpayer and £762 a year if you are an additional rate payer.

6. Use your annual capital gains tax-free allowance

For investments held outside an Isa or pension, the annual capital Gains tax-free allowance is very valuable. Investors can make investment gains of up to £12,300 in 2020/21 without paying any tax. 

Gains over that amount are added to income and if they fall in the basic rate tax band are taxed at 10 per cent and if they fall in the higher rate tax band are taxed at 20 per cent. An additional 8 per cent is added to the tax rate if the gains are from a second property.

The annual capital gains tax-free allowance cannot be carried forward into future years so if you don’t use it, you lose it. If you have investments with gains outside of an ISA or pension you should consider whether to realise some of that gain before the end the tax year to make the most of your tax-free allowance. 

You can also transfer investments to your spouse, in order to use their annual CGT allowance.

7. Get your tax-free personal allowance back

The tax-free personal allowance for most people is currently £12,500. When your taxable income reaches £100,000, your personal allowance is cut by £1 for every £2 of your income, which means you lose it completely once your income reaches £125,000.

For example, someone who gets a payrise from £100,000 to £110,000 will lose £5,000 of their personal allowance. They will be taxed at 40 per cent on their payrise, amounting to £4,000, and then taxed at 40 per cent on their lost personal allowance, amounting to £2,000. This means they pay £6,000 on the £10,000 pay rise – an effective tax rate of 60 per cent.

The tax-free personal allowance for most people is currently £12,500

The tax-free personal allowance for most people is currently £12,500

If you are in this position you could consider reducing your taxable income so that it falls below the £100,000 level where the personal allowance starts to be eroded. You can do this by making charity donations or contributing to a pension. 

By contributing to a pension you are a making tax savings in the form of getting your personal allowance back whilst also saving for your future and benefiting from pension tax relief at 40 per cent, so you wipe out the 60 per cent effective tax rate completely.

8. Ensure you continue to receive child benefit

All parents are entitled to child benefit, but as soon as one of them earns more than £50,000 they will see the amount they get whittled away, before the benefit is completely wiped out when they earn £60,000 or more.

A parent with two children will get £1,820. a year in child benefit, but for every £1,000 they earn over £50,000 they will lose 10 per cent of their child benefit – so someone earning £51,000 will lose £182.

However, parents who haven’t tipped too far over the threshold can get around this by increasing their pension contributions. What’s counted for the purposes of the child benefit ‘High Income Charge’ is your salary after any pension deductions. This means if you contribute enough to your pension to get your salary back to £49,999 then you’ll get the full child benefit again. 

Another option is to make charitable donations from the income over the £50,000 limit, which you’ll need to declare to HMRC on your tax return.

However, the frustrating factor for many parents is that the rule applies if one parent is earning more than £50,000, regardless of their partner’s income. So, you could have both parents earning £48,000 each and have no problem, but if one earns nothing and the other earns £60,000 then you’ll lose the benefit. 

While there are ways around the charge, ultimately some people will struggle to contribute enough to their pension to bring their income down below the £50,000 limit.

9. Start saving for your children

Like adults, children also have tax allowances that can be used each year. The Junior Isa allowance is now a very generous £9,000 a year which enables you to start building a very healthy fund to help them transition into their adult lives. They won’t be able to access the money until they are 18, at which point it automatically turns into a normal Isa and transfers into their name, giving them full access. 

Saving for your children: The Junior Isa allowance is now a very generous £9,000 a year

Saving for your children: The Junior Isa allowance is now a very generous £9,000 a year

If you contribute the maximum £9,000 each year and achieved a 4.5% investment return after charges each year, the pot would be worth just over £252,000 by the time your child turns 18. If they don’t touch the fund and don’t pay any more into it, the pot would be worth £1million by the time they turn 50.

You can also pay up to £2,880 into a Junior SIPP each year, with Government tax relief automatically boosting that to £3,600. Your child won’t be able to access the money until they are at least age 57, maybe later if the Government increases the age limit. This ensures there is plenty of time for them to benefit from compound investment returns. 

If you paid in the maximum each year until your child turns 18 and then they don’t contribute anything else, assuming 4.5 per cent investment returns each year after charges, the pot would be worth just under £562,000 by the time they turn 57 or just over £835,000 by the time they hit the current state pension age of 66.

10. Consider lifetime gifts

Gifting money in your lifetime needs careful consideration to avoid any surprise tax bills. Lifetime cash gifts are known as PETs or potentially exempt transfers and can create an inheritance tax charge if you, as the donor, pass away within seven years of the date of the gift. 

However, you also have an annual gift allowance of £3,000 and any unused allowance from the previous tax year can be carried forward. Gifts of up to £250 made to an individual are also exempt each tax year. 

You can also make regular gifts of any size out of surplus income without paying tax, provided your lifestyle is not affected. 

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