How to beat higher tax bills

Regardless of the outcome of the election, millions of taxpayers across the income scale already face higher tax bills in the financial year just started.

The new 50 per cent top rate of tax on incomes over £150,000, and a reduction in personal allowances for those with incomes over £100,000, are the most obvious tax rises to come into force in 2010/11, costing wealthy individuals up to thousands of pounds in additional income tax.

For incomes over £100,000 – including interest and dividends – personal allowances are now reduced on a tapered basis, and completely withdrawn at £112,950 and above. With the 40 per cent higher rate that already applies at this level, this allowance clawback creates an effective tax rate of 60 per cent on incomes between these levels.

However, many other individuals will be subject to 40 per cent tax on more of their income, and even some lower-income pensioners may face bigger tax bills.

John Whiting, tax policy director at the Chartered Institute of Taxation, says: “Those really being hit are in the £100k+ bracket, but most people will pay more income tax [this year].”

This is because personal allowances and the income level at which 40 per cent tax kicks in have also been frozen for 2010/11. The standard personal allowance remains at £6,475, while the so-called higher-rate threshold stays at £43,875.

Individuals in the higher-rate band and whose incomes rise will pay more tax at the 40 per cent rate, while some middle-earners receiving a salary increase will pay the 40 per cent rate for the first time – an effect called “fiscal drag”.

Age-related allowances also stay at £9,490 for those aged 65-74, and £9,640 for 75 and over – so some older people could face more tax at 20 per cent.

Rising tax bills boost the appeal of tax shelters and reliefs, say financial advisers. Here are some ways to beat the increases.

Pensions

Upfront tax relief on pension contributions is restricted for the highest earners on incomes over £130,000. But, for most people above the 40 per cent threshold, such investments remain an effective way of offsetting tax rises.

Laith Khalaf, pensions analyst at Hargreaves Lansdown, says that for those on incomes over £100,000, contributing to a pension can allow personal allowances to be reclaimed and so deliver up to 60 per cent relief. He calls this a “once in a generation opportunity” – the highest rate of relief available on pension contributions since the 1980s.

Meanwhile, those earning over £150,000 can get 50 per cent tax relief on up to £20,000 of gross contributions (in some cases £30,000) – albeit only for this year. Advisers also urge other high earners to take advantage of their 40 per cent tax relief while it remains available. There are fears that this relief could be further curtailed after the election.

Isas

While not offering upfront tax relief, Isas protect investment returns from income and capital gains taxes. The annual allowance has increased to £10,200 this year – of which £5,100 can be in a cash Isa – allowing all holders to ringfence greater sums from potentially higher tax rates.

Bed-and-Isa/Bed-and-Sipp

Switching portfolio investments into Isas or self-invested personal pensions (Sipps) shelters holdings from ongoing tax. With Sipps, the upfront tax relief means that investors can pocket a tax rebate or reduction in their overall tax bill.

Growth investments

With capital gains tax (CGT) at 18 per cent – though many expect the rate to rise after the election – it could make sense to favour growth-oriented holdings. Hargreaves Lansdown advises sheltering income-generating investments in Isas or pensions, so saving up to 50 per cent income tax on interest and up to 32.5 per cent on dividends.

Offset mortgages

For high earners who have taxed savings and a mortgage, Moneysupermarket.com, the comparison service, suggests switching to an offset loan to earn tax-free returns on spare cash while retaining access to those funds.

Charity donations

Donations under Gift Aid are boosted by 28 per cent of tax relief in the hands of the charity, while individuals over the higher-rate tax threshold can also claim additional personal relief.

A 50 per cent taxpayer is entitled to £37.50 of relief for every £100 donated, according to the Charities Aid Foundation. However, if this personal tax relief were also donated, the charity would receive a total of £176.28 for each £100 donation. As with pensions, charity donations by those on incomes over £100,000 can allow personal allowances to be reclaimed – boosting the effective tax relief to about 60 per cent.

VCTs/EISs

Venture Capital Trusts offer upfront income tax relief of 30 per cent, while Enterprise Investment Schemes give 20 per cent. Income and gains from VCTs are tax-free, while EISs allow investors to defer existing capital gains. Both schemes involve investing in small and higher-risk businesses.