Unexpected tax traps to watch out for – and how not to fall into them
The UK’s complex tax system presents plenty of pitfalls – from failing to claim pension tax relief to making bad decisions in retirement. Here are the main ones to be aware of…
- The complexity and ever-changing nature of the UK tax system means that even the most savvy can risk shock tax bills or miss valuable opportunities.
- Many of us walk into tax traps without even knowing it, whether missing out on annual allowances, failing to claim tax reliefs or making hasty pension-income decisions.
- While the start and end of the tax year are the obvious times to review tax matters, only by planning ahead and getting advice can you be sure of avoiding expensive mistakes.
With a rule book thousands of pages thick and regulations seemingly changing all the time, the UK’s tax system is famously complex. It means that for many people, tax represents much more of a threat than an opportunity, with pitfalls at every turn. From investing in a way that incurs much more tax than is necessary to making pension-income decisions without being aware of potentially expensive tax implications, even the most financially savvy among us can fall foul of the UK’s many tax rules and regulations.
The full list of errors to avoid and opportunities that shouldn’t be missed is a long one. But here are some of the most common and costly tax traps to look out for.
Forgetting to share the load
Most tax allowances, exemptions and tax-efficient investment opportunities are available to each person in a couple. For example, if only one person in a couple has used up their ISA allowance for the current tax year, they can gift some money to their partner who has some or all of their allowance left. The same approach can be taken to each person’s annual Capital Gains Tax (CGT) allowance.
Leaving it to the last minute
Many of us are in the habit of paying attention to our allowances only at the start and/or end of each tax year, says Tony Wickenden, Joint Managing Director of Technical Connection (a St. James's Place group company). “This can mean it may be too late to use them, especially Income Tax allowances and exemptions that can’t be carried forward,” he explains.
Joining the tax-free cash rush
A common mistake among those reaching retirement and accessing their pension is to take all their tax-free cash in one go, says Claire Trott, Divisional Director for Retirement and Holistic Planning at SJP. “It can be used as income in most Defined Contribution (DC) pension schemes to help reduce the Income Tax paid each year, so if you don’t need the lump sum to pay off something, then don’t take it all out,” she explains. “Also, if taken out and not spent, it can increase your Inheritance Tax (IHT) liability.”
Saying no to free money
A surprising number of people forget (or decide not) to reclaim certain payments to which they’re entitled. For example, some higher-rate and additional-rate taxpayers fail to reclaim the pension tax relief they’re due, while the tax relief offered on gifts to charities can also be overlooked. “This can be done via self-assessment or by calling HMRC with the figures,” says Claire.
Not reviewing opportunities annually
A common pitfall is not realising that many potentially significant tax-saving opportunities come around every year, according to Tony. These include the £20,000 ISA allowance, the £2,000 dividend allowance and the £12,300 CGT allowance, all of which are lost for good if they aren’t used during the tax year. “Over a number of years, not taking advantage of these ‘use it or lose it’ opportunities can cause serious tax damage,” says Tony.
Getting caught by the 60% rate
The way the personal allowance works creates what’s effectively a 60% Income Tax rate on earnings between £100,000 and £125,140. That’s because if you earn £100,000 or more, your £12,570 personal allowance is reduced at a rate of £1 for every £2 above £100,000. So, for every £100 of income between £100,000 and £125,140, you get only £40 to take home, with £40 taken through Income Tax and another £20 lost due to the gradual removal of the personal allowance – amounting to an effective tax rate of 60%. Perhaps the most common way to mitigate this is to reduce your taxable income by using allowances such as your pension.
Avoiding the pitfalls
Perhaps the best way to ensure you don’t fall into any tax traps is to plan ahead, ideally with the help of a professional financial adviser.
“Tax-saving strategy is always best planned before the tax year starts, so that it can be executed in a structured way throughout the year – rather than left to the last minute, when some opportunities may no longer be available,” says Tony.
Tax year-end planning is still worth doing, but you’re likely to get better outcomes from planning in advance too.
This is a complicated area where most mistakes can be easily avoided. It makes a lot of sense to seek specialist, experienced advice when it comes to tax and how it affects your wider financial plans.
“A great way to ensure that you at least consider all of the opportunities to minimise your tax bill is to have your adviser run through a tax health check with you,” says Tony.
The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.