If you go out and work hard for a living as an Average PAYE Joe then I'm firmly with your current scoffing. These guys and girls are I agree taxed heavily here in the UK. 20%, 40% and 45% are the well known tax rates. On top of this you have the less well known effective 60% tax rate that is in play once you earn a £100,000 until you've lost all your personal tax-free allowance. We also shouldn't forget about 12% employee and 13.8% employer national insurance contributions which are just taxes via another name and which add onto those well known tax rates. It’s a very tax hungry country for a worker.
Let’s however now enter the world of FIRE (financially independent retired early) or even just Retired. What can you now ‘earn’ and not pay tax on (of course these rules also apply to PAYE workers):
- From 06 April 2016 the personal tax-free allowance for earnings will be £10,800. The Tories have also stated that they will increase this to £12,500 by April 2020. Only after that are we into the 20%, 40% and 45% tax discussion. Our retiree's pension drawdown will be considered earnings so will be taxed according to this.
- From 06 April 2016 the current Dividend Tax Credit will be replaced by a new £5,000 Dividend Allowance meaning you will be tax-free on the first £5,000 of your dividend income no matter what non-dividend income you have. So let’s say our retiree has non-tax sheltered shares that are giving 4% in dividends per year. They could have share wealth of up to £125,000 outside any tax shelter and be tax free on all the dividends.
- Similarly from 06 April 2016 a tax-free Personal Savings Allowance of £1,000 (or £500 for higher rate taxpayers) on the interest that you earn on your savings will come into play. At current interest rates that allows a lot of capital in savings accounts outside tax shelters before tax comes anywhere near. Perfect for somebody like myself who intends to live off the dividends in FIRE and needs a cash buffer.
- On top of this you can also take whatever you've accrued within your ISA’s tax free. This could be a substantial sum. I started investing in ISA’s late and even though I’ll FIRE relatively early I still expect my ISA pot to be £150,000 or so at the point of FIRE. Take 4% in dividends/interest/capital from there and you have another £6,000 or so of ‘income’.
- If you need to do any non-tax sheltered tinkering then also don’t forget about the capital gains tax-free allowance. That’s another £11,100 for tax year 2015/2016.
- Then finally the icing on the cake. Our retiree is not exposed to National Insurance contributions but they can get free healthcare at the point of use.
As I work towards FIRE I'm also trying to avoid (remember avoidance is legal, evasion isn't) as much tax as possible. This includes salary sacrificing into a pension meaning I’m saving 20%/40%/45% tax plus both employees and most of the employers (my company adds 10% of the 13.8% to my pension) national insurance contributions now in exchange for paying tax on it during withdrawal. As I mentioned above I’m currently planning (and of course the rules have a habit of changing regularly) on that later tax rate being 0%.
Government are currently considering tinkering with this and the tinkering could very much affect the level of avoidance via a pension that a 40%/45% taxpayer like myself can achieve going forward. I would encourage everyone to read Merryn Somerset Webb’s article ‘Our stupidly complicated pensions regime’ in this weekend’s Financial Times (I have a deal with the FT where if you click through on the link provided you should be able to freely see the article). She summarises far more succinctly than me but surmises that instead of that 40%/45% tax deferral ‘we will probably end up with an incentive worth in the region of 30p in the pound’ which will not be called ‘a tax relief but a top-up’.
At budget time it was clear that something was up and I personally have positioned myself to really maximise the amount of salary I’m sacrificing into my pension this tax year, at the expense of cash savings for a family home, with the full expectation that I’ll then heavily reduce pension contributions next year when pensions are less attractive. They’ve already started by stating that next year the annual contribution allowance will be reduced to between £10,000 and £30,000 depending on your earnings but as Merryn highlights there looks to be much more to come.
I personally expect to nearly sacrifice £40,000 into my pension this financial year. It’s worth also remembering that this 2015/2016 tax year there is a quirk in the annual contribution allowance. As a reminder it looks like this:
- If you have contributed less than £40,000 to your pension between the 06 April 2015 and the 08 July 2015 (budget day) then these contributions do not count towards the current year’s £40,000 allowance. Effectively this means you have a new £40,000 allowance from the 09 July 2015.
- If you made a £40,000 and £80,000 contribution during that time your current allowance is £80,000 minus these contributions.
- If you made a contribution of more than £80,000 then you don’t have any remaining allowance. That said don’t forget you might be able to add more using the carry forward rules.
As always DYOR.