Be on your guard, high earners and buy-to-let investors

If anyone has the right to feel nervous in the run up to Budget day it’s high earners and buy to let investors. Both are seen by pressure groups as unfair winners in the current tax system and both are regular targets when it comes to tax raising measures. Landlords for example have previously lost higher rate mortgage relief and gained a special rate of stamp duty while high earners have had their entitlement to tax free allowances chipped away.

Many small business owners will fall into one of the above categories but this group has an additional reason to worry. The Institute for Fiscal Studies has published a report (Taxing Work and investment: pathways to well-designed taxes) arguing that the five million Brits who work for their own companies enjoy a huge and unfair tax advantage over employees. It has called for standardised rates for everyone – whether employee or self employed - with no get-outs such as savings on national insurance, meaning higher tax bills for anyone running their own business.

Nothing may be decided in the short term but for this chancellor and his successors, the budget is no longer simply a question of moving numbers around a page - now there is a mammoth bill to pay and drastic action is called for (we outline some potential tax changes here). Below we look at different steps high earners, business owners and buy to let investors can take to improve their tax efficiency ahead of potentially detrimental changes coming their way.

Two additional pension options

Higher rate and additional rate taxpayers have something to fear in the coming budget given speculation that this might be the one when the axe finally falls on the top two rates of relief on pension contributions. These reliefs are incredibly valuable and for as long as they are available, investors who can, should exploit the tax break to the hilt. If the top rate of relief is taken away and limited to basic rate then the cost to an additional rate pension saver will rise from £55 to £80 for every £100 of personal contribution made.

It makes sense therefore to use this year’s full allowance if you can, and to consider the two other common ways of boosting pension contributions if they are available to you. The first is through carry forward, and the second is through employer contributions. Carry forward is not as straightforward as it might first appear. While it is designed to allow you to use up unused pension allowance from the three previous tax years, the rules can be an obstacle. First, you must have been a member of a pension scheme during the previous years, then you need to have used up the whole of the current year’s allowance and finally all the allowances being used when added up cannot exceed your total earnings in the current tax year. 

Someone earning £60,000 who has an unused carry forward allowance of £40,000 might assume they can make a personal contribution of £80,000 in the current tax year. But their personal contributions would be limited by their earnings in the current tax year which is £60,000. They can contribute £40,000 from this year’s allowance and £20,000 of unused allowance from a previous year.

However, there is a way to make full use of carry forward and that is through employer contributions. These are not constrained in the same way as personal contributions, although employer contributions which exceed the maximum total amount the individual is entitled to in a single year would be subject to a tax charge, which would depend on your other income and where you live in the UK - the excess above the available annual allowance would be added to your other income, and taxed accordingly.

“If you own your business then you can make an employer contribution that is not limited by your earnings,” says Colin Low, chartered financial planner at Kingsfleet Wealth. “If the business has £500,000 in the bank, then an employer contribution could be made of say £160,000 made up of a contribution for the current tax year and carry forward from previous years.” 

However any employer contribution must be “wholly and exclusively” for the benefit of the business. "The amount paid therefore," says Low “would need to be in proportion to what you earn for it to be allowable. If someone has been drawing a salary of £80,000 to £90,000 a year then a pension contribution of this amount would not be unreasonable.”

Besides being an efficient way to allocate money for your own resources from your business, making a pension contribution in this way benefits the business too as it’s an expense that can be offset against turnover meaning a lower corporation tax bill.

Tapering trap for high earners

If your earnings are around or above the £200,000 level, you need to be particularly careful when it comes to employer-made pension contributions. That’s because pension contributions from your employer will be included in the Tapered Annual Allowance earnings calculations warns Gary Smith, chartered financial planner at Tilney. Anyone with earnings (from all sources including buy to let income) at or above £240,000 will start to see a drop in their annual tax relieved pensions allowance – all the way down to £4000 if your earnings amount to £312,000.

“Many people don’t realise their employer’s contributions count towards the TAA,” says Smith. “Someone who runs their own business and earns £220,000 might believe they are not affected by the TAA. But if the business makes an employer pension contribution of £40,000, then they will lose £10,000 of pension allowance, leaving them with just £30,000. If they do not have £10,000 of unused pension allowance to carry forward they will be taxed personally on that £10,000.”

There are two tests for the TAA. The first looks at threshold income which is your income from all sources less any pension contributions you personally make. If your threshold income falls below £200,000 then the second TAA test is not carried out and your annual £40k pensions allowance remains available. If your threshold income is above £200,000 then a test for adjusted income is carried out and now all income including employer pension contributions will be added into the calculation. For every £2 of income above £240,000, you will lose £1 of annual pensions allowance.

Working out when you are in danger of hitting the TAA is much more difficult if you are a member of a defined benefit scheme because the calculations are not based on actual contributions and you may not be aware you have breached a limit until it is too late. Even if you are entirely ignorant of that fact, you will be held liable so if you are in that danger zone it’s probably well worth speaking to a tax or pensions adviser.

Other ways of getting around the TAA include transferring income generating assets to a spouse or civil partner with lower income (see Buy to Let below). “You may not be able to control your employment income but you can reduce other income streams,” says Smith.

Worked example: Joan Wilson’s pension

Joan Wilson runs a software company and pays herself a salary of £210,000. She has £40,000 of carried forward allowance to utilise and she would like to the business to make a pension contribution of £80,000 in the current tax year.

If Joan’s business made the full £80,000 pension contribution and Joan made no personal contribution, her threshold earnings would remain above £200,000 and so the second test – Adjusted Income – would be applied. “In this case the adjusted earnings would be found to be £290,000, and the individual’s Tapered Allowance would fall to £15,000. This would be added to the carried forward amount of £40,000 giving her £55,000 of allowance,” says Gary Smith at Tilney. She would therefore face a tax charge on the excess contribution of £25,000 at 45 per cent. 

However, if Joan herself pays £10,000.01 into a pension her threshold income will fall below £200,000 and she will receive tax relief on her £10,001 contribution. "Her company can then pay £69,999 into her pension,” says Smith.

This scenario where the individual makes a personal contribution (securing tax relief at 45 per cent) with her business paying the balance of just under £70,000, delivers a better outcome and no pension allowance is lost.

Avoiding the 60 per cent tax rate

Anyone earning £100,000 and above starts to lose their tax free personal allowance, adding thousands to their tax bill each year. For every £2 of earnings above this £100,000 threshold, you lose £1 of personal allowance so at £125,000 you have no tax free personal allowance. Effectively your tax rate becomes 60 per cent. If you are in this 60 per cent tax band then your aim should be to get yourself out.

You can do this through pensions contributions and also gift aid contributions because your entitlement to the full personal allowance is only calculated after these contributions are deducted from your earnings. And, points out Smith, for anyone in the £100,000 to £125,000 danger zone, making a pension contribution is even more tax efficient than for someone earning below this threshold. “Let’s say someone earned £110,000 this year and didn’t make any pension contribution. They will pay an effective tax rate of 60 per cent on the £10,000 above £100,000. However if that same person contributed £10,000 to their pension, they would keep their full personal allowance which with pension tax relief adds up to an effective relief rate of 60 per cent,” he says.

Allocating income generating assets to a spouse is another way to steer clear of tax traps.

If you have income other than from employment, or a sole trader business, consider giving this to a spouse or civil partner if they have lower earnings, says Rob Pullen, partner at Blick Rothenberg. “The income from such assets would be assessed on them, providing the gift is absolute and there are no strings attached. You can currently give assets to a spouse or civil partner without incurring capital gains tax.”

If your partner has no employment or rental income, and you have a big bank balance or bonds kicking out interest, “then you can get a significant amount income to them tax free by utilising a combination of their personal allowance (£12,500), the zero per cent savings band (£5,000), the tax free personal savings allowance (£1000 for a basic rate taxpayer) and tax free dividend allowance of £2,000,” says Pullen. “It adds up quite a lot of tax free income. If you are earning more than £150,000, and keep this income for yourself, you would be paying 45 per cent on that income and 38.1 per cent on the dividends.”

Buy to let

Splitting income from buy to let properties with a spouse or civil partner can lead to significant tax savings for your household. It can also ensure that you avoid the 60 per cent tax rate (on income between £100,000 and £125,000), and protect your entitlement to the full pensions annual allowance of £40,000.

By transferring a small part of the property - which could be as low as 1 per cent - into a lower earning spouse or civil partner’s name, HMRC will assume the income from the property is split equally between you. With such a small percentage transfer this should not create any stamp duty land tax liability, says Pullen. “Obviously inform the bank first to ensure there is no issue if you have a mortgage on the property, and consider the wider implications of making an absolute gift.”

Not only are you potentially keeping your own income below the 60 per cent tax threshold, but by utilising your spouse’s 20 per cent tax band, for that portion of the mortgage interest that is deductible from your spouse's rental income, it’s as though the mortgage relief restriction never happened.

Another option is to set up a limited company for any new buy to let purchases. This way mortgage interest can be deducted from the rental income in full and if rental income is left within the business (it will be taxed at 19 per cent) then it won’t count towards your annual earnings.