Neil MacGillivray discusses the impact of recent changes to personal allowances on your clients' pension planning
In this year’s budget, great emphasis was placed on the continued large increases in the personal allowance. The allowance increased by £1,335 to £9,440 in the tax year 2013/14 and the much heralded increase to £10,000, is being brought in a year ahead of schedule in 2014/15.
This means, come April 2014, the personal allowance will have increased by over 54% in just four years. But, and it is a big but, there is an underlying trend which has not received as much publicity and this could have a significant impact on your clients’ planning decisions.
On the upside, all appears to be good news; 2.7 million low income individuals under 65 lifted out of paying income tax by April 2014, an estimated 24.5m individuals will benefit from the 2014/15 changes and the typical basic rate taxpayer will be better off by £705 in cash terms from April 2014.
Now for the downside; the figure that has been ignored is the increase in the number of higher rate tax payers; a rise from four million in April 2012 to an estimated five million in April 2014. During these difficult economic times, when salary increases are very low or even non existent, how can this be the case?
As the personal allowance has increased, so the basic rate tax band has been reduced. This is in part to finance the cost of the rise in the personal allowance and to ensure that higher rate taxpayers do not fully benefit from any increase. In 2010/11 the upper limit of the basic rate band was £37,400. In 2014/15 it will be £31,865 a reduction of £5,535.
If we combine the personal allowance increases with the basic rate band reductions over the same period, a further £2,010 of income will be subject to higher rate tax in 2014/15, which four years earlier would only have been subject to tax at the basic rate.
This creeping of income into the 40% tax bracket may have gone unnoticed by your clients as overall they may have benefited, even if only slightly, from some tax saving over this time period. The magic figure on the bottom right hand corner of their payslip may not have warned them that they are now a 40% taxpayer, or paying more of their income at the 40% rate.
The impact on the investment return for a 40% taxpayer can be quite substantial, compared to that of a basic rate taxpayer, though whether this is a positive or negative aspect depends on the type of investment vehicle used.
This is best demonstrated by way of an example. The table below shows the potential returns, net of income tax, over a 40 year period for a monthly investment of £100. The investment vehicles chosen are a bank deposit, an ISA and a personal pension plan.
In respect of the pension contributions, the gross amount invested each month would be £125 for a basic rate taxpayer and £166.67 for a 40% taxpayer. The rate of growth on each of these investments is assumed to be 5% gross per annum with the growth rate on the bank account for the 20% and 40% rate taxpayer being 4% and 3% net of tax respectively. Investment return is calculated on a compound basis capitalised annually.
For basic rate taxpayers, the tax free aspects of an ISA and the ability to fully access the investment at any time may be seen as sufficient reason to forgo the immediate 20% tax relief on pension contributions.
Although there are risks associated with this approach, one can see the merits in it. In the case of a 40% taxpayer there is a considerable difference of £156,154 in the potential return between money invested in a bank account to that invested into a personal pension.
Also the higher return of just under £100,000 between a pension plan and an ISA for a 40% taxpayer may be enough to incentivise a client to consider the option of contributing to a pension.
The trend for narrowing the basic rate band is set to continue, with it restricted to a 1% increase in 2014/15 and 2015/16. This will gradually lead to more people falling into the 40% band, with some being totally unaware of the 40% tax creep. It does however provide a great opportunity for advisers to promote the tax benefits of pensions for 40% taxpayers.
*Personal allowance and basic rate tax band 2009/10 to 2014/15
Neil MacGillivray is head of technical support unit at James Hay Partnership
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