Thu. Jan 27th, 2022

Courtesy of complex tax rules, higher income and inheritance tax (IHT) rates are much higher than one might think. And it is the wealthy who are trapped by these higher rates, not the super-rich.

First we do income tax. Most people know that they are entitled to a personal allowance each year – an amount of income that they can earn without having to pay any taxes. In 2021-22 it is worth £ 12,570.

What you may not realize is that once your income exceeds £ 100,000, you start to lose your allowance, at the rate of £ 1 for every £ 2 earned above that threshold.

As a result, while the highest rate of income tax is, in theory, only 40%, going up to the additional 45% rate on income over £ 150,000, you can pay much more. With income between £ 100,000 and £ 125,140, ​​you will actually pay 60%.

Fiscal complexity

Something similar happens with IHT. In theory, the zero residence strip is a generous bonus. The standard zero rate range is £ 325,000 or £ 650,000 for couples, and IHT should only be paid on farms above this limit.

But in addition, if you leave your main home to your direct heirs (children or grandchildren), you will be able to get an additional £ 175,000 allowance or £ 350,000 for couples. In general, then, many couples have an IHT grant worth £ 1 billion, including the value of their home.

So far, so good. But, as with the personal income tax bonus, the null residence strip is reduced once your property exceeds a certain amount (currently £ 2 million). You lose 1 GBP for every 2 GBP you exceed this limit. The effect is that your heirs face a 60% bill on the value of your property between £ 2 million and £ 2.7 million.

Treasury likes these stirrups so much that it has introduced a similar trick with pension savings, where most people can contribute up to £ 40,000 a year to private pensions.

In this case, if your income exceeds £ 240,000 a year (income is quite technically defined in pension regulation), you lose £ 1 of this annual allowance for every £ 2 above the threshold, up to that your annual endowment be reduced to only £ 4,000. when revenue reaches £ 312,000. With the tax charges to be paid if the subsidy is exceeded, the effect can be huge.

These complex boundaries were introduced by two chancellors, who began their careers at 11 Downing Street by pledging to simplify the tax system.

The reduction in personal expenses was introduced by Labor Alasdair Darling in 2009. George Osborne introduced slimming around the IHT and pension contributions.

It was Osborne who created the Office of Tax Simplification. Suffice it to say that when he left office, the book of tax rules had gone from 11,500 pages to 17,806!

Philip Hammond commissioned a report to simplify IHT in 2018. The Treasury is still considering its recommendations.

How to Avoid Tax Reduction Traps

The good news is that once you know these pitfalls exist, you can take action to prevent them. Take the conical personal allowance. One option is to invest your income above £ 100,000 in a private pension as it reduces taxable income. Effectively, you will get a 60% tax deduction on this contribution.

Another option would be to use your excess income to make charitable donations. In this way, HM Revenue & Customs maintains the additional tax that should be paid from the hands of HM Revenue & Customs and, instead, places it in the account of the charity.

Depending on your circumstances and situation, you may not be able to fully mitigate your income tax reduction. But even if you only make modest additional pension contributions or charitable donations, you will continue to reduce the success you will get.

Meanwhile, at IHT, the key is to plan early with the help of professional advice. In practice, there are many different ways to reduce the value of your estate, so when it is passed on to your heirs, the IHT bill is reduced or does not exist.

For example, you can make many small gifts without any IHT involvement, while larger gifts are usually “potentially exempt transfers” (PET). The value of these PETs does not leave your property as long as you live at least seven years after they are manufactured.

Also, remember that the money left to the heirs of a private pension is exempt from IHT. Maximizing pension savings, and then taking advantage of other savings first in later life, can be an excellent way to plan for wealth.

My advice to the current chancellor would be to undo the ribbons. I am not convinced that they raise as much money for the Treasury as for the accountants, solicitors, and financial planners who have to help people deal with it.

Until they are rejected, watch out for these conical traps and, if it affects you, consult them. It will cost you, but smart planning can also save you thousands of people.

See also: How to avoid wealth tax by mitigating risk in four ways – Charles Calkin advises on risk mitigation to avoid the worst of wealth taxes.

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