Tax planning is one of the best ways to look after your finances. But taxes on retirement income and your estate can sometimes be complicated to understand. Below is a short glossary explaining the essential terms you need to know, answering questions like:
- What income is taxable?
- What reductions apply to your income tax?
- How is your inheritance taxed?
In the coming weeks, we will look into each term in more detail to ensure you have all the information you need to aid your tax planning.
What income is taxable?
First, we’ll look at terms surrounding income tax. Are pensions taxed? If so, are there any exemptions?
Taxable income refers to money you receive that’s subject to tax. The most common type of taxable income includes:
- Earned income, such as wages, pension payments and profits from self-employment.
- Certain state benefits such as Carer’s Allowance and Jobseeker’s Allowance.
- Income from savings and investment such as dividends, income from property letting, bank or building society interest.
Income tax can be deducted at source, leaving you to receive it net. Alternatively, you might receive income without the tax deduction, which means you receive it gross.
A payment made by the government to individuals who have paid or been credited sufficient National Insurance contributions. The payment is made on a weekly or monthly basis after you reach the state pension age. The state pension is a taxable form of income.
Workplace and personal pensions
A workplace pension is a scheme your employer has to provide by law. There are two types of workplace pension schemes:
- Occupational pension schemes, which can be final salary or money purchase schemes.
- Group personal pensions or stakeholder pensions in which your employer chooses the pension provider, but you have individual contact with the provider.
The latter can be taken privately, independent of your employer. In these, you pay contributions to the pension fund from your wages or any other income you receive.
Savings and investment income
Income you receive as an extra from your savings or investments. It can be in the form of interest your bank pays or dividends you receive from a stock fund. Savings and investment income is taxable income, but you can reduce the amount subject to tax with allowances.
An income-related state benefit paid to people who are over the state pension age. It consists of two parts: Guarantee Credit and Savings Credit. Guarantee Credit is paid for those whose weekly income is below a specific level. Savings Credit is an additional payment for people who saved money towards retirement. Pension Credit is not taxable income.
How can you reduce your taxes?
You can enjoy specific tax allowances that can reduce the amount of tax you pay. Below are the tax allowances you need to know about, together with an explanation of what they mean.
Tax allowances help you reduce or limit the amount of tax you pay on your income. There are various tax allowances available to you, depending on your specific circumstances. The main tax allowance is the Personal Allowance, which applies to all taxpayers. Other tax allowances include the Marriage Allowance, which is only available to married couples, and the Property Allowance is for property owners.
This is the most common tax allowance and available to most UK residents. The personal allowance reduces your taxable income, meaning you only pay tax on the income you receive above the set threshold. Anything below the threshold won't be subject to tax, although technically, it is still taxable income. The personal allowance is an annual allowance that cannot be carried forward, even if you don’t use it.
Blind person’s allowance
An additional allowance on top of the personal allowance, reducing the amount of income on which you must pay tax. You can use the Blind Person’s Allowance (BPA) if you are:
- Registered as blind with a local authority in England and Wales.
- Live in Scotland or Northern Ireland, and your sight is so bad that it stops you from performing any work for which eyesight is essential.
BPA doesn’t depend on your income level, meaning it's always the same regardless of how much money you earn.
This is an allowance for married couples and civil partners. The marriage allowance is also known as the Transferable Tax Allowance. It allows you to transfer some of your personal allowance to your spouse or civil partner with a tax credit. With the allowance, you can transfer £1,250 to your spouse or civil partner.
There is another allowance available to married couples. Married Couple’s Allowance is a bit more generous, but it’s not available to all couples. Married Couple’s Allowance is only available if one of you was born before 6 April 1935. The allowance can reduce your tax bill between £351 and £907.50 per year.
You can use the trading allowance against any trading, casual or miscellaneous income. The trading allowance allows you to deduct up to £1,000 each tax-year in tax-free allowances for any trading income.
The Property Allowance is available to anyone who has income from a property. For example, if you are letting a room or a holiday home. Like the trading allowance, the property allowance allows you to deduct up to £1,000 each tax year against any income you receive from the property.
Personal savings allowance
Personal Savings Allowance (PSA) lets you earn interest on your savings without paying tax on that interest. The allowance depends on the rate of income tax you have to pay. Therefore, PSA doesn’t reduce your payable tax the same way that the other above allowances do.
The PSA applies to returns classed as savings income. This includes interest payments from various sources, income from corporate bonds and gilts, and purchased life annuity payments.
The dividend allowance works like PSA. If you earn any income from dividends, then you can earn a certain amount of dividend income without having to pay tax on it. Above the limit, special rates of tax apply, and the rate depends on your total income.
Nordens Chartered Accountants’ Tax Manager, Adam Truluck, believes: “Tax planning can range from simple to complicated, with many different options that can save you tax now and in the future. I highly advise anyone taking the time to put the correct planning in place as this can become very expensive and time consuming later down the line.”
What happens to the money you leave behind?
We can’t control the time and place of our death. What happens to the money and possessions you leave behind? Knowing how to reduce your inheritance tax is an integral part of planning your taxes, even though you won’t be there to witness what happens. Here are the key terms to understand around inheritance tax.
Inheritance tax / The nil rate band
Inheritance tax is a tax on the estate of a deceased person. The estate includes money, possessions and property of the person. The standard rate is charged only on the part of the estate that’s above your tax-free threshold. Inheritance tax is only payable after a person has died, and you can’t pay it in advance. Inheritance tax is often called the nil rate band. The nil rate band specifically refers to the threshold above which inheritance tax is payable.
Your inheritance tax thresholds can differ if you use the marriage exemption. You should also be aware that gifts given up to seven years before death might be subject to inheritance tax.
Married couples and civil partners can pass their estate to their spouse when they die. In effect, the surviving spouse can inherit the entire estate without having to pay inheritance tax. It is also possible to pass the unused tax-free allowance to their surviving spouse or civil partner, increasing the surviving spouse or partner's future nil rate band.
You don’t usually have to pay inheritance tax on small gifts you make out of your regular income. Gifts between spouses or civil partners are also exempt. But other, non-exempt gifts count towards the value of your estate. You might need to pay tax on gifts according to the seven-year rule, with the rates depending on when you gave the gift.
Gifts subject to Inheritance tax are taxed on a sliding scale. This scale is known as ‘taper relief’. You pay less tax on gifts that were given three or more years before the person died.
Understanding tax planning jargon
When you start preparing your retirement finances, tax planning is a big part of the process. Understanding the jargon can help make the most of different tax allowances. In the coming weeks, we’ll take a deeper dive into the above terms and make sure you can plan your taxes without problems.