Income Tax Planning – How to reduce your tax burden

Why should individuals resort to income tax planning rather than make a straightforward calculation and pay the tax liability?

Regardless of whether anyone engages in employment, self employment or business, income tax is more or less a certainty. However, income tax is not levied as a straightforward percentage of the total income. The law provides many allowances and relief, and exploiting such provisions allows reduction of your income tax liability considerably. The many conditions that come with availing such benefits make Income Tax Planning indispensable.

What is Taxable Income?

Income Tax is a tax on income. However, not all income attracts income tax. Generally, income from employment or self-employment, pensions, interest of savings, dividends from shares, rental income and income gained from a trust attract income tax, subject to certain reliefs or allowances that the law may permit.

Taxable income includes income from:

  • Employment, including income from full, part-time and temporary employment, most perks or benefits associated with the employment, and net profits from self-employment
  • State or personal pension, retirement annuities, pensioner bonds and trust income
  • Interest on savings from bank and building society accounts, national Savings and Investments accounts and bonds, dividends on company shares
  • State benefits such as Carer’s Allowance, Jobseeker’s Allowance, Employment and Support Allowance, Incapacity Benefit beyond 29 weeks and Weekly Bereavement Allowance
  • Rental income from a lodger, if more than £4,250 a year in your only house, or the entire rental income from a second property

The UK tax year runs from 6 April to 5 April, and the taxable income attracts income tax at different bands depending on the income level.

What is non-taxable income?

The law ignores certain income when computing “taxable income,” meaning that such incomes are exempt from income tax. The most common of such non-taxable incomes are

  • State benefits such as Disability Living Allowance, Attendance Allowance, Lump Sum Bereavement Payments, Pension Credit, Winter Fuel Payments, Housing Benefit, Income-Based Employment and Support Allowance, First 28 weeks of Incapacity Benefit, Child Benefit, Guardian’s Allowance, Maternity Allowance, Industrial Injuries Benefit, Severe Disablement Allowance, War Widow’s Pension and Young Person’s Bridging Allowance
  • Interest on individual savings accounts and savings certificates
  • First £4,250 of rental income from a lodger in the individual’s only home
  • Working Tax and Child Tax Credit
  • Wins from Premium Bonds

The law also provides many other relief and allowances that reduce Income Tax liability on taxable income.

What is “Savings” and “Non Savings” Income, and how does it make a difference on Income tax liability?

“Non savings income” is income from employment or self-employment, most pension income, and rental income.

“Savings income” is basically dividend income from shares in UK companies. Such income adds on to non-savings taxable income and is taxed last, meaning that taxes on savings income occur at the highest applicable income tax band.

What are the allowances and relief that reduce Income Tax?

A number of allowances and relief make it possible to reduce your income tax liability on taxable income.

The law provides a certain income tax-free “personal allowance” for individuals with annual income less than £100,000. For 2011-12, this basic Personal Allowance is £7,475 for people below 65 years, £9,940 for people between 65 and 74 years, and £10,090 for people above 74 years. Taxable income up to this amount attracts 0 percent tax.

The other allowances available on taxable income are:

  • Married Couple’s Allowance, for a spouse or civil partner born before 6 April 1935. The allowance depends on the individual’s income, subject to a maximum allowance of £7,295 and the minimum amount of £2,800. The tax benefit is 10 per cent of the allowance amount
  • Maintenance Payment Relief for a tax payer, former spouse or civil partner born before 6 April 1935. The tax relief is £280 for maintenance payments above £2,800 or more a year, or the actual amount paid for maintenance payments less than £2,800
  • Blind Person’s allowance, for people registered blind or unable to perform any work which requires eyesight. The allowance is £1,980 without any age or income restrictions.

Contributions to company or public service pension schemes and charities attract further income tax relief.

How Do Pension Payments Result in Income Tax Relief?

Payment of pension does not result in direct income tax savings. However, the pension provider claims back tax from the government at the basic rate of 20 per cent. This means that for every contribution of £80, the payee gets £100 worth of pension. Higher rate taxpayers (those in the 30 percent or 40 percent bands) may claim the corresponding difference by making a claim through telephone or letter. Additional rate taxpayers (50 percent) may claim the difference through tax returns.

How do Donations Help to Reduce Income Tax?

Gifting of land, property or qualifying shares and securities to a charity, or selling such assets to a charity at less than market value attracts both income tax and capital gains tax relief. The value of such gifts is deducted from the taxable income.

In addition, the “Gift Aid” and “Payroll Giving” schemes, while not providing direct tax relief, increase the value of the donation by allowing the recipient to reclaim from the government the tax paid on such donations.

How does Gift Aid work?

Gift Aid does not result in any direct tax savings, but allows increasing the value of donation to charities and community amateur sports clubs (CASC). The law allows the charity or the CASC receiving the donation to reclaim the 20 percent basic rate tax on the donation. People paying tax at the higher rate can claim the difference through their tax returns.

How does Payroll Giving work?

Payroll Giving is making donations to charity directly from payroll or pension. The employer, on authorization from the employee, deducts such donations after contribution to National Insurance but before Income Tax deduction. This means only the amount left over after the donation attracts income tax, effectively providing tax relief at the highest rate of tax.

Does Availing of Company Benefits Rather than Salary Help to Reduce Income Tax Liability?

An employee or a director of a company may claim income tax relief for the amount spent on travelling for work related purposes, purchase of work clothes or tools, professional fees, expenses for working from home and other expenses related to doing the job. The law allows deducting such expenses from total income before deriving taxable income. However, company directors with annual income of £8,500 or more, including the value of benefits, do not enjoy such exception and have to pay tax on all benefits.

Employees working in a company may enjoy benefits such as value of food availed from the staff canteen, car parking near place of work, hot drinks and water at work, mobile phone, Christmas parties and childcare without paying tax on such benefits.

The value of most other benefits such as company cars and fuel spent on them, medical insurance, living accommodation and loans with a low interest rate, or interest free loans greater than £5,000, attract income tax. The value of such benefits is included when calculating taxable income.

There are certain grey areas in deciding whether the value of work related benefits attracts income tax or not. For instance, the benefit accruing out of living accommodation provided by the company attracts income tax liability by default, but if one can prove that such accommodation allows doing the job better, then it is ignored when calculating taxable income. Similarly, the value of medical insurance benefit attracts income tax, but insurance to cover treatment when working abroad and the value of annual check-ups are exempt from income tax.

What income tax breaks are available for the self-employed?

Self-employed individuals may claim income tax relief for all business-related expenses, such as purchase of capital machinery, stock or materials, payroll expenses, costs associated with renting and maintaining business premises, business travel costs, advertising expenses, legal and professional fees, and other general office costs.

Items used both for business and personal use, such as a telephone or use of a car still become eligible for income tax relief. The law allows splitting up such expenses and claiming tax relief for the proportion used for business purposes, provided such a split is possible. The single biggest test on whether the expenditure would be entitled for tax breaks is whether the personal received any private benefit from the expenditure. The law holds that the person should not have received such a benefit, and that any personal benefit was incidental and not the reason for the expenditure

However, certain expenditure such as cost of entertaining guests do not quality for income tax exemption.

The key requirement to claim such tax relief is to maintain proper and detailed records of business expenses

How does the type or nature of occupation influence income tax?

Certain self-employed professionals may avail income tax relief by averaging their income. For instance, farmers, market gardeners or artists may reduce income tax liability by averaging profits over two years.

In many cases, self employed professionals may be better off incorporating their business. UK corporation tax rates are much lower than top income tax rates, and moreover dividends are taxed less than other types of income.

The law also allows a spouse or partner to run the company and split the income, which would almost always lower the income tax bill.

Individuals with business losses may claim overlap tax credit by setting-off the loss through other income for the same or previous years.