159- Tax Misconceptions

The last two episodes have focused on the myths surrounding pensions and ISAs. In this episode Benjamin reviews the main tax misconceptions we all typically share. 

By the end of this episode you'll hopefully feel a lot more positive about tax, have some tax planning ideas you can take into your own financial plans, and no longer view tax as a bad thing but instead a success fee. 

Join Benjamin Mitchell (themoneyscot), serial hater of financial jargon, as he helps make your finances clearer and ensures you never make another financial mistake.

Getting on top of your personal finances doesn't need to be complicated or scary. Arm yourself with the only knowledge you need to transform yourself from money novice to money nerd! 

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Disclaimer - please note that nothing in this podcast can be relied upon as financial advice and the content is provided purely for information and guidance purposes. Please seek independent, regulated financial advice relevant to your situation.

Transcript

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SPEAKER_00 0:10

Well, hello money nerds, it's Benjamin Mitchell here. Thank you again for joining me on Heads Up on Money. This is episode 159. It's an absolutely riveting one because we're talking about the misconceptions around tax. Promise, I promise it's not gonna be as dull as that. So in previous episodes of Heads Up on Money, as you'll have known, we're talking about the Misconceptions series, trying to debunk some of the common myths surrounding financial planning and personal finances to try and improve your knowledge and make you feel a little bit better about your financial planning. So we talked in the first episode about pensions, in the second, we talked about ISAs. In this episode, we're talking more generally about tax. Because tax is one of the things that just gets us feeling all uptight and tuning out, and uh, we don't really want to think about it. It's very much the Pandora's box of financial planning, but I'm hoping by the end of this episode, which I will try as always to keep short and sweet, or as short and sweet as I can on my soapbox, hopefully you'll be feeling a little more clued up about tax and a little bit more confident. So that's what I want to achieve today. And if you hang around to the end, I'm hoping you'll feel a lot better about tax and maybe you've taken away a few tax saving ideas as well. So if you are enjoying Heads Up on Money, it's just a call out for me as always to say please do like, subscribe, comment if you're listening on Apple Podcasts, because it really gives me a shot in the arm to know that you're actually enjoying Heads Up on Money, you're getting value from the podcast, and also it helps spread the word for the podcast to more people, get more people finding heads up on money, and more people finding their financial futures with greater confidence. So thank you. As always, from me, Money Nerds, it really does mean so much to me that you're listening to me every Friday. So talking about tax misconceptions. When you raise the subject of tax with people, there's normally one of two one of two reactions I get. First is either that's that's way too complicated, I'm not interested, or yeah, tax planning, that's more about what rich people do to avoid paying tax, isn't it? We're talking offshore planning and complex investment vehicles and tax avoidance schemes, but both of these are misconceptions. It's understanding the rules that apply to you and making sensible decisions about when you receive certain levels of income, the manner in which you hold certain investments, how you save for retirement, and understanding which allowances and reliefs you're entitled to. Tax planning is not as glamorous as it might sound when it's about offshore planning and tax avoidance schemes, and only for the uber wealthy, it's not all that. Tax planning is for you and for me, and can actually make a real difference to your financial plans and, by extension, your ability to meet your financial life goals. You just need to understand the rules and understand, as I said, which apply to you, and then adapt your planning around them. And there's a really important distinction here because HMRC itself makes the distinction between legitimate tax planning and tax avoidance. Using reliefs in a planned and structured way is very much what the government intended: contributing to pensions, investing through ISAs, sheltering your wealth from income tax, capital gains tax, avoiding as much inheritance tax as possible. It's all legit tax planning. Tax avoidance, on the other hand, involves agreements designed to obtain a tax advantage that the government never planned for. So we're talking today about the misconceptions around tax planning. Hopefully, fingers crossed, by the end of this episode you'll have a much better idea of what legitimate tax planning can look like. So, misconception number one, tax planning. What does that mean? It simply means avoiding paying tax. Well, tax planning doesn't necessarily mean tax avoidance. If the government gives you an ISA allowance and you use that ISA allowance, as we talked about in last week's episode, you're not doing anything wrong. If you're entitled to pension tax relief, and most people are, again, won't get into the weeds in this episode, but generally speaking, you can contribute as much as you earn into a pension subject to the annual allowance. Even if you don't have any earnings, you can still pay in 2880, and that gets a little bit of tax relief. And typically, up until you're 75, this applies to you. But basically, you can pay into a pension, you can get the free money tax relief, and you're not doing anything wrong. That's not tax avoidance, that's good, legitimate tax planning. If you're entitled to the marriage allowance and you claim it, you're not doing anything wrong. These are all simply examples of using the tax system in the way it was designed. Where things become very different, as I said, is when someone starts talking about an arrangement that exists primarily to manufacture a tax advantage. That is very much the realm of tax avoidance. So what I would caution you, money nerds, is if something sounds too good to be true in the world of investments and the marketing around it is driven by tax advantages, you'll pay no tax, no tax liabilities. That is red flag, red flag, red flag. If it's too good to be true, it probably is. I'm going to talk through the main tax planning routes today, and these are pretty much the bread and butter of most legitimate tax planning angles you can take. If you're getting promised something that seems too good to be true, then it probably is. So, misconception. Let's go. If I earn one pound more, I'll pay thousands in tax. It's a common misconception, and admittedly, before I started out in the world of financial planning and getting into personal finance, this is one I actually thought too. I thought it was the case that as soon as you earn one pound more, you suddenly go up to a new tax band, and as a result, all of your income is now subject to that new tax band, and you could pay thousands and thousands more just through earning one pound of extra income. So there's a some grain of truth in some of this. For instance, if someone says you don't earn more than the basic rate tax relief upper threshold, because if you earn more than that, you'll end up paying higher rate tax relief on all of your income. Or for instance, if you go over 100 grand, you'll lose the entirety of your personal allowance. But these are misconceptions because the UK tax system operates on a banding system, so an incremental system that goes up, up, up through different levels of income, through different levels of tax band. So as a result, you need to be familiar with the term your marginal rate of tax. Because what that basically means is the marginal tax you're going to pay on all of your income just through earning an extra pound of income. So if you suddenly encroach into the higher rate threshold because you've received a nice bonus this year, that doesn't mean all the income you've enjoyed at the basic rate is now going to be subject to the higher rate. It just means every pound of extra income you earn thereafter will be subject to the higher rate threshold. So it just means up to a certain level you'll perhaps pay, let's say, 20%, and above that you'll pay 40%. So it's not as punitive and scary as you might think it is. Again, I'll reiterate this: the UK tax system is based on tax bans. And on the point of the personal allowance being lost, I've done an episode of the podcast on this historically. The personal allowance gets tapered away if you earn over a hundred grand. But importantly, with the argument I'm trying to make here is if you earn that extra pound, it'll take you over the £100,000 threshold, but you don't suddenly pay the higher rate on all of your income. Only the relevant slice is taxed at the higher rate. So think of your income as going through different buckets, and within each bucket, they will have their own tax rates applicable to them. So it's not as scary as it might seem. So don't turn down a pay rise just because someone tells you you'll lose it all in tax. You won't, you'll pay more tax, but you're still going to earn more. The net position is still going to be better for you in most cases. On that subject, the misconception around £100,000 tax trap means you're suddenly going to pay 60% tax. That's not necessarily true because there's a point around £100,000 where your factive marginal income tax rate can be much higher than people expect. Recap for every two pounds of adjusted net income above £100,000, you lose one pound of your personal allowance. So once your income gets sufficiently high, your entire personal allowance has been washed out. So someone earning just above £100,000 can find themselves in a very different position from someone earning just below it. So for example, depending on your circumstances, it may be beneficial, guidance, not advice, for you to make a pension contribution so as to reduce your adjusted net income back below that £100,000 level. That can be really good legitimate tax planning. That can potentially restore some or all of your personal allowance, and you also get tax relief on the pension contribution. So it can be beautiful tax planning, legitimate tax planning. But you need to be aware of this fact that there's a horrible window above 100 grand where you won't necessarily pay the classic higher rate tax relief on any incremental income. You actually pay more than that. In some cases in Scotland, it can be even more than 60% in this case. So be aware of this danger zone and be aware that there's legitimate tax planning you can do surrounding it that the government encourages, and you should strongly consider doing if you're engaging in financial planning by yourself or speak to your financial advisor to make sure you're doing it in the right way. Next misconception: all of my income is taxed in the exact same way. So that's another biggie. Income has lots of different flavors and takes lots of different forms. You may have salary income, you may have taxable pension income, you might have interest from savings, you may have dividends, whether that's dividends from a limited company, you may be a director of or a shareholder of, you may have dividends from an investment portfolio that's perhaps not wrapped within an ISA or a pension, it might be in a general investment account, you may have rental income, you may have a buy-to-let property. The point is that each of these may have their own levels of tax. The most prevalent recent example of this is that property income taxes are going to go up. So ordinarily, rental income from a property was just charged in the same way as your salary or earned income. That's now going to have its own different level of tax rate. Dividends have their own tax rate. Pension income falls within your kind of classic levels of income tax as if you were earning or you had a bonus. The point I really want you to take away, money nerds, in this example, is that the tax system isn't necessarily simple as saying if your total income is £80,000, and let's say £50,000 of that was your salary, and then £30,000 of that was from a property that you rented out, that was your taxable profits. It's not necessarily the case that you're going to be by default a 40% taxpayer, so you'll be 40% on broadly income you earn. It's more subtle than that, it's more nuanced. Savings income can be different to dividend income, which can then be different to earned income. So it's just understanding that all of your income is not necessarily taxed in the same way, and that then invites you to structure your income to optimize the level of tax you pay, perhaps by looking at the various tax bands and trying to make sure you're not overweight into one area. Misconception number five: the order in which income is taxed doesn't matter, and this is one of the things that most people have never been told. So for income tax purposes, the calculation isn't simply you add everything together and apply one percentage. As I said, there are rules governing how different types of income are treated. Broadly, non-savings income is dealt with first, then it comes things like savings and dividend income, then you've got things like capital gains tax, there's an order of taxation, and if you speak to your accountant, you can actually structure this in the most tax-efficient way for you, more often than not. So I'm not going to get into that area of tax planning in this episode, but it's understanding that there's an order of taxation, but you do have some flexibility in order to use that order of taxation and structure it in the most advantageous way for your own tax return. So many people don't understand that. If you've got an accountant, they should be keeping you right with that. Another misconception I see is that people tend to assume if they have an investment portfolio, that only becomes relevant if they were to sell their investments. Tax only rears its ugly head at that point. And that's true to an extent because capital gains on your investments, if they're not held in an ISA, so let's park tax wrappers aside. Let's assume you've got a general investment account because maybe you've got a restriction as to how much you can park in an ISA or park in a pension in any one tax year. You've got a general account. When you sell, that is when capital gains comes into the fore. That's when the mixed capital gains comes in, and you've got control over that. You can control your timings, you can perhaps use it against your annual capital gains tax exemption to avoid how much capital gains tax you might pay. But please do also keep in mind that there's ongoing income tax liabilities that may arise within your investment portfolio in the form of dividend income. Let's assume it's going to be dividends if you've got a largely equity-backed portfolio. Dividend income will be accruing within your general investment account, and that is immediately susceptible to income tax, regardless of whether that is paid out or not. Now, what I mean by that is the funds that you hold within your general account will typically be one of two flavors. They will be accumulation funds or income funds. And people tend to assume that if they've got an income fund and the dividends get paid out as cash, and perhaps you withdraw that perhaps every month as an income, an additional little bit of money to live on, they assume you know that may be taxable, that may be subject to dividend tax, although most people don't declare it. But if you're in an accumulation unit where you've opted that the funds that you hold will instead of paying out cash and paying out income to you, they instead use that dividends to buy more units in the funds, and the snowball grows and compounding grows and all the great things that should happen, you still are subject to income tax on that accumulation dividend. So point to take here, Money Nerds, is regardless of whether you've got income units or accumulation units, in a general investment account, you may have dividend tax liabilities that are arising and need to be declared to HMRC. HMRC are tightening down on this and they're they're now getting it so that platform providers send these taxable statements to HMRC to notify them. So it's becoming very unlikely that you're going to avoid this going forward. So being transparent, being open is the best policy. But the misconception I see is people assume if they've got a general investment account, they haven't made any sales, they haven't incurred any capital gains tax, they tend to assume there's no tax liability therein. Well, that is not the case. You have ongoing tax implications and liabilities that do arise. And this has invited the popularity of the investment bond wrapper. Again, I have done an episode of the podcast on this a few months back, episode 148, investment bonds. Should my financial plan have one? The reason investment bonds have become so popular is because of the fact that people who are rolled in capital gains tax susceptible investments in a general investment account, the fact that the capital gains tax allowance has gone down, the dividend allowances have gone down, more and more of your unwrapped income and gains are being subject to tax, which is inviting the possibility of do you then structure your investments in another tax wrapper beyond pensions and ISAs, such as an investment bond. There's no right or wrong answer, as that episode alludes to. It depends on your financial plan, but I would encourage you to listen to that episode if you haven't already, just to understand the other opportunities available to you for legitimate tax planning if you're paying a lot in the way of tax, perhaps, on your general investment account. So, misconception: you do potentially pay tax on your investments regardless of whether or not you are selling them. The next misconception or thing that really annoys me with tax planning is that many people kind of view tax planning as an end of tax year retrospective look back to see how much tax have I paid? Is there anything I can claim to reduce that tax? And this is very much from the from the mindset of an accountant. Now I'm not discrediting accountants in any way. I know lots of great accountants that add huge value for their clients, but accountants typically are very backward looking. You speak to your accountant normally at the end of the tax year and work out how much tax have I paid? Is there anything I can optimize or structure to reduce that level of tax? Whereas financial planning and taking ownership of your financial future is much more proactive. You're thinking forward in this tax year, questioning what level of income am I likely to have in each of these buckets? How can I structure things in a tax-efficient way? For example, let's say you are exhausting your ISA allowance, you're exhausting your pension allowance, you can't pay much into pensions because you don't have taxable income to justify the contribution. So as a result, you've got a sizable amount and a general investment account. Are you married? Should you be considering using your spouse's ISA allowance? Should you be considering using your spouse's pension allowance as he or she perhaps may be able to get more into a pension in a tax-efficient way than you can? Looking at things holistically, working out are you triggering higher rates of tax when your spouse is a nil rate taxpayer? Are you realizing gains within your investment portfolio when you've already exhausted your capital gains tax exemption and your spouse could use theirs by you transferring assets to them on a spousal transfer basis whereby the gain moves over to them? There's lots of legitimate tax planning you can undergo, and you really need to sit down, allocate half an hour just to work out the level of taxes you're paying, what flavor of income or capital gains you have in your financial plan, where they're going to sit, and look at your holistic family tax rate to understand where's the best place to hold these assets, who's the best person to own them, when should we make disposals, should we be using ISAs, should we be using pensions? Should we be using general accounts? It's about being proactive money nerds. That's when the best tax planning happens. And obviously, if you're sitting down with a financial planner once a year, you'll have this all nailed down. But if you're doing this yourselves, as I encourage many money nerds to do, sit down at the start of a tax year and work this out. If you've got surplus capital, park it in an ISA earlier in the tax year rather than later. Because anything that's parked in later will have sat out with the ISA environment and will potentially have accrued income tax liability and or capital gains tax liabilities. So park it in the ISA, park it in the tax wrapper as soon as you can. It's harder to do so with pensions, as I appreciate, because sometimes with pensions you don't know what the level of income you may have for a tax year will be, and it can be difficult to estimate the level of pension tax you're perhaps going to be able to to, or level of pension contribution I should say, you're able to pay into your pension. It's harder with pensions, I get that, but what I often do with some of my clients is we'll pay in the minimum level, which is 2880, which gets grossed up to 3,600, and then at the end of the tax year we may do a sweep up exercise working out how much of their annual allowance is still remaining, and then pay in the remainder. But with ISA planning, it's really simple. If you've got the surplus capital there and it's within your financial plan to either invest that capital for the long term or park it in a cash asset for the shorter term, you should be doing it. If you take away one thing from today's episode, Money Nerd, it's that proactivity is key. But lastly, the final point I will make around tax is that not to become scared of it, not to hate it. Tax is a success fee. I'll let that sink in. Tax is just a success fee. If you're paying tax, it means something is going well. And the biggest caution I would give you, money, is to not let the tax tail wag the investment dog. I've talked about that saying before. What it means is that don't let tax saving be the driver. Again, I alluded to it earlier. If something seems too good to be true in the world of tax planning, it probably is. The greater determinant to your long-term success, your ability or inability to meet your financial goals won't be driven by the tax savings therein. The investments you have, the assets you're allocating to, that's going to be the important thing. Tax planning comes later. Understanding that is absolutely key. You can optimize your financial plan in the best possible way to pay the least amount of tax, both now and in the future. That is good financial planning, but ultimately there are more important determinants to your long-term success. So don't become hung up on taxes. That's what I want you to leave this episode with, Money Nerds. Yes, taxes are important. Nobody wants to pay more tax than they need to, but you nail this stuff down later on. Understand, as I said before, what your goals are, what type of assets you need to allocate to in order to meet those goals now and in the future, and then you start to think about tightening things up. Then you start to think about do I allocate to pensions? Do I allocate to ISIS? Should we be realizing gains in my partner's name or my name? These are all the subtleties, these are all the nuances, but do not let the tax tale wag the investment dog. Tax means something is going well in your financial plan. Tax planning is legitimate, tax avoidance isn't, and tax planning when done best is proactive rather than reactive. So I hope this has given you lots of food for thought. I'm going to wrap it up there. If this has been helpful and not too boring, please let me know. I love to hear from you, Money Nerds. If you've got any other things you wish for me to cover in future episodes of the podcast as well, do give me a nudge. I really like hearing suggestions from the listeners. As if it matters to you, it probably matters to someone else. If you've got a burning question, it's probable so does someone else. I've been Benjamin Mitchell, you've been the Money Nerds. This has been Heads Up on Money episode 159, talking about tax misconceptions. I will see you next Friday for this all over again. Until then, have a nice weekend. I hope the sun is shining wherever you are and you're enjoying the end of the summer. Oh, it's depressing saying that. I'll see you next Friday. Take care and goodbye for now.