1. Marginal tax rates
In the UK there are several headline rates of tax. For example, if your a basic rate taxpayer then your income is taxed at 20%, 40% for higher rate or 45% for additional rate payers.
But what some people don’t realise is that even those in the 40% tax band can in fact end up paying tax at 60%. How can that be? Well, as your income rises some allowances and reliefs that you were previously entitled to are withdrawn or disappear. This can lead to taxpayers suffering a disproportionately high effective rate of tax.
So, if you don’t keep a pretty close eye on your income levels, then you could just find it’s being taxed at a nasty effective rate.
So, what sort of reliefs can be withdrawn?
- If your income is between £50,000 – £60,000 and you are claiming child benefit, then you will be subject to the High-Income child benefit charge. It’s withdrawn at a rate of 1% for every £100 of additional income between £50,000 and £60,000 meaning once you reach an income of £60,000 it will be withdrawn in full. That’s still the case even if one parents income is £60,000 and the other isn’t working. So, if your income is around this level then it’s worth looking at ways to mitigate this.
- If your income is between £100,000 – £125,000 your personal allowance will start to be withdrawn. You lose £1 of your personal allowance for every £2 of income over £100,000 meaning by £125,000 it’s been withdrawn in full. This is an effective tax rate of 60% meaning if your income is around this level, it’s worth looking at a few simple tax reliefs like pensions.
- If you don’t carefully manage your salary and dividends, then you may find you breach a tax band and move in to the higher or additional rate. Sometimes small adjustments to the timing of dividends can avoid entering higher rates so it’s worth checking with your accountant before taking a dividend.
The withdrawal of these reliefs means it’s essential you’re in constant communication with your accountant or tax adviser to make sure you’re not going to get hit with a big tax bill.
2. Forgotten ISA allowances
The humble ISA can often be overlooked, but they remain a highly tax efficient wrapper for growing your income.
Known as an Individual Savings Account (ISA), you can save up to £20,000 into a cash or stocks and shares ISA each year. As this is a tax-free wrapper any interest from cash ISA’s or Dividends and Gains from stocks and shares ISA’s are completely tax free.
ISA’s are a good tool to have in your saving armoury alongside pensions as most can be accessed fairly quickly, unlike pensions which are typically locked away until your aged at least 55 (and that’s set to rise).
3. Overdrawn Directors loans
There can be times where a Director owes the company money. That’s not uncommon, and with the changes to the Companies Act 2006, an overdrawn Directors Loan Account isn’t illegal. But there can be several tax consequences.
Where the loan is overdrawn at the company’s year-end and remains overdrawn 9 months and one day after the company’s yearend then a 32.5% tax charge arises on the balance of the outstanding loan. So, for a Director with a loan of £50,000 that remains unpaid after 9 months a tax charge of £16,250 will occur and this is payable by the company to HMRC.
There can be other tax consequences too, including interest on the overdrawn amount as otherwise a benefit in kind will arise. Check out our guide to Directors Loan Accounts to find out more.
4. Forgotten pension allowances
Don’t make the mistake of forgetting about pensions. They are a highly tax efficient way of reducing your tax bill, both for your company and for you personally.
As a Director of an owner-managed business you may be able to make a pension contribution of £40,000 direct from your company to a personal pension scheme.
This is tax deductible for the company, and goes into your pension pot tax free.
Note that any contribution over and above the £40,000 annual allowance will be subject to an income tax charge.
Find out more about director’s pensions in our article.
5. Poorly split income
It’s not uncommon for one person in the family to earn more than the other. But this can cause a problem when it comes to staying tax efficient.
That’s because the higher earner will be paying tax at higher tax rates, despite the fact their spouse or partner may not be working.
One thing to consider is whether you can set your affairs up more tax efficiently. You can look at gifting assets between spouses, or splitting income generating assets.
If you’re a business owner, splitting share ownership between you and your spouse, or family members, can greatly increase tax-efficiency. This is because each family member has their own set of personal allowances and income thresholds, so splitting profits between several family members can reduce the overall tax liability.
This means a sole Director/shareholder currently taking £100k of Dividends and paying higher rate tax of 32.5% could become a basic rate taxpayer by splitting share ownership 50/50 with their spouse. Both of you will now be basic rate taxpayers (just!) with dividends subject to tax at 7.5%.
The more family shareholders, the more people profits can be shared between, increasing the overall tax-efficiency.
6. Forgotten tax free benefits
There are lots of tax-free or low tax benefits for owner managed businesses to take advantage of. We’ve covered many of these in our 15 tax free benefits guide but they include:
- Mobile phones
- Annual parties
- Trivial benefits of up to £300 per years
- Pension contributions
- Electric cars & vans
- Electric car charging
- Use of home
Wrapping up
Most owner managed businesses may have an accountant managing their compliance and filing requirements, but are you certain they’re actively managing your tax affairs?
If they’re not, then you could end up with a surprise tax bill at the end of the year.
At Raw, we believe all business owners should understand the fundamentals when it comes to accounting and tax and we closely work with our clients to proactively manage their tax position.
For those currently managing their own affairs, it’s crucial you keep a close eye on your income and maximise your tax free reliefs and allowances to help reduce your tax bill.
Need a bit of help? Then get in touch and let’s have a chat.
