Stealth tax buried in Kwasi Kwarteng budget
Consider someone who earned exactly last year’s threshold of £12,570 ($13,476) and therefore paid no tax. This year, their wages may have increased by 9.9% to match the latest CPI reading. They would now earn £13,814 but are no better off in real terms. If the tax threshold remains at £12,570, they will now pay £248 in tax (20% of this year’s pay rise) and will therefore be worse off.
With inflation far higher than Sunak had originally forecast, the Institute for Fiscal Studies estimates that this so-called fiscal drag will cost taxpayers around 30 billion pounds ($32.5 billion).
But income tax thresholds weren’t the only allowances to be frozen in that fateful 2021 budget. Capital gains tax (CGT) and inheritance tax thresholds (IHT) were also frozen, as was the lifetime pension allowance. The new government of Liz Truss kept all of that in place. This makes tax planning both more important and complicated.
For the Treasury, the benefit of freezing the thresholds is relatively simple. Inheritance tax revenue reached £6.1bn in 2021-22, up 14% on the previous year. Capital gains tax, meanwhile, contributed £14.3bn to the Treasury coffers, a 42% increase on the previous year. (To be fair, it wasn’t just the tax drag that boosted CGT revenue. Some commercial reliefs were reduced, and buy-to-let landlords also paid significantly more CGT when they exited the property market.) .)
For taxpayers, the frozen thresholds make it even more important to plan carefully for long-term investment goals like retirement.
Pension contributions generally attract relief at a person’s marginal tax rate. For someone earning less than £50,270 a year, every £80 they contribute to their pension is topped up with an additional £20 tax relief to bring the total to £100. For those earning over £50,270, the relief is even more generous: a contribution of £60 attracts £40 of relief.
When it comes to retirement, however, withdrawing your pension can be tax-efficient, but it’s not tax-free. Generally, you can withdraw a quarter of your pot tax-free, but the rest is taxed as earned income and that’s where frozen income tax thresholds add to the bite. When these are frozen, withdrawing more money from your pension fund to offset inflation will inevitably mean paying more taxes.
Pensions remain good business, and the vast majority are completely unaffected by the volatility in the gilt market that has so stressed providers of lucrative but increasingly scarce pensions. But there is a limit to the tax relief the government will give an individual. Any retirement savings over the rather arbitrary sum of £1,073,100 are taxed at 55% if you withdraw the money as a lump sum. If you withdraw the excess as regular income, you pay a 20% penalty on top of your marginal tax rate.
Fortunately, there is an investment vehicle with additional tax benefits to a pension. An Individual Savings Account (ISA) does not attract tax relief on contributions, but you can withdraw money entirely without income tax, and ISAs also enjoy CGT benefits similar to pensions. And although you can usually only pay £20,000 a year into an ISA, you can grow your portfolio as big as you want without facing criminal taxation.
Therefore, a promising retirement and estate planning strategy is to combine these two products to break through the freeze threshold and enjoy the best of both worlds. Ideally, you would reduce your retirement contributions in favor of ISA savings if you were concerned that your retirement pot was likely to exceed the retirement lifetime allowance.
There is a key consideration, however, when juggling pensions and ISAs. The former can be very successful in terms of inheritance tax, which is important given the freezing of the IHT thresholds. ISAs, on the other hand, do not benefit from such an exemption from the IHT. This means that when it comes to retirement, you should opt out of ISAs first, as they offer income tax exemption, but no inheritance tax protection. Every pound you spend from your ISA is not only exempt from income tax, but can also reduce your potential estate tax.
Of course, there are more subtle variations around these themes, which usually require the assistance of a financial advisor. Still, even with random freezes and variable allowances, it’s possible to build a viable retirement income strategy while leaving a tax-efficient legacy for your loved ones.
Much of this ingenuity would be utterly useless if government policy were applied in a simple and predictable way. Investors may appreciate tax breaks, but what they want above all else is certainty and consistency.
More from Bloomberg Opinion:
• Truss’ economic plan isn’t the disaster everyone says: Tyler Cowen
• Why Investors Face Even Greater Market Instability: Mohamed A. El-Erian
• Bank of England right to snub calls for emergency action: Mark Gilbert
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Stuart Trow is co-host of “Money, Money, Money” on Switch Radio and author of “The Bluffer’s Guide to Economics.” Previously, he was a strategist at the European Bank for Reconstruction and Development.
More stories like this are available at bloomberg.com/opinion