Working with the Tax Man
Hi all,
Well, do I have an incredibly interesting topic to discuss with you today… INCOME TAX!
While this seems to be insurmountable, I think there are ways we can work *with* the taxman to set ourselves up. Of course, I think tax is a good thing and am happy to live in a country where we have nice roads, social support and a great *free* health service (this house loves the NHS).
Before we begin, I agree with you that the numbers used in the below examples are aspirational for many and certainly cannot be generalised. I chose to use these as I could not find such examples online and it was an interesting challenge reading tax guidelines/law (lol)…
*** As usual this is not advice. At best entertainment, at worst conversation starters with a professional***
I have been speaking to friends and I quickly realised that I know barely anything about tax. Time to change this. I noticed that higher tax brackets come with some interesting nuances, so I will investigate these here.
What is income tax?
Income tax is the tax paid on any salaried income that you receive. It is also paid on some types of crypto activities such as staking (I had to mention crypto ;) ). Depending on your tax situation, you pay a different amount of tax. See below (Apr ‘21 - Apr ‘22)
To help us with this, meet James, Josephine, and Julie. James earns £40k a year, Josephine earns £120k and Julie £200k. Here I will think about how much tax they pay and how they can optimise for this.
I assume no student finance debt and no other measures or reliefs that can reduce tax. We will ignore national insurance for now.
Personal Allowance
As you can see above, tax is only paid when you earn over c.£12.5k. Hence:
Here, you notice a few things, (i) Josephine’s personal allowance is lower than £12.5k and (ii) Julie has £0? This is because our Personal Allowance goes down by £1 for every £2 that our adjusted net income increases above £100,000. This means our allowance is zero if our income is £125,140+ (UK Gov). To reiterate, <£100k and one’s personal allowance is like James’.
Hence:
Other Types of Tax
Long story short, we can run the maths on the basic, higher and additional tax rates.
Using the above guidelines:
We can see a few things here
James: Pre-tax income is below the higher rate/additional tax rate thresholds hence pays no higher rate
Josephine: Pre-tax income is below the additional tax rate threshold hence pays no additional rate tax. Their effective tax is c.x2 James’ but they earn x3.
Julie: Pay across all tax bands but their effective tax rate is 6% higher than Josephine despite Julie earning c.66% more.
This spring ups interesting thoughts on the discussions regarding “taxing the rich” but that is out of the scope of this blog post.
But it gets even more interesting.
… (i hope).
Now let’s talk about Pension Contributions
The tl;dr is that (i) by contributing to our pension, we can reduce the tax we pay (DYOR) (ii) locking up £100k into a pension *may* make someone an old millionaire
Point 1: We reduce our taxes by paying into our pension
Let us assume that James, Josephine and Julie (i) all contribute 5% to their pension (ii) their employer contributes 0% and (iii) does not match their contributions.
NB: Employers paying into your pension does not impact tax maths here. It increases your pot but does not impact the reduction in tax
Here, we see that by paying into their pension, their “pay” (taxable income) reduces. Due to this, as I will show, their tax payout decreases. This, friends, is crucial. But how crucial?!
Let’s run tax figures again:
James has a pre-tax income of £40k. When James sacrifices £2.4k of this (row D) their actual take home amount increases by £480. In other words, a 6% contribution means James’ pays c.£500 less in tax per year.
Josephine has a pre-tax income of £120k. When Josephine sacrifices £7.2k of this (row D) their actual take home amount increases by £5k.
It is important to realise that while our top line “income” reduces, (i) this reduction goes into our pension pot and (ii) our actual take home increases! Hence, we pay less tax by preparing for our future.
NOTE!
There is a maximum of £40,000 a year that someone can pay into their pension. Hence, the contribution % needed for maximum tax saving is equal to £40,000 / total pre-tax income. We can see this in the following chart. As expected, after a point, it levels out.
In other words, at the “peak”, that is the maximum tax saving that we get for contributing £40,000 into our pension. We can easily see that this technique is not viable for James.
*NOTE* Please seek professional advice, while we would save in tax, our take home pay decreases.
2. Old Millionaire Status
I agree with you, sacrificing a large % of our salary is tough. From concerns about opportunity cost, using funds to buy a house/crypto/anything, and simply using it to have fun, I hear you. Bear with me here.
Each year there is a cap of £40k that we can pay into our pension
There is also a cap on the total lifetime value of our pension. Above this, we pay tax on any gains. This is called the lifetime allowance. It is currently £1,073,100.” - UK Gov
Assume you are 25, have a payout age of 60, and an annual return on your pension of 7%.
Hence: £1,073,100 = n*(1+7%)^(60-25) → n = £101k.
What does this mean?
The faster one reaches £100k locked up into a pension… they are all but guaranteeing millionaire status. *Insert obvious caveats*
Wow.
Here’s the kicker… you can “self-direct” your pension investing via SIPPs. Hence this fund is not even locked to you.
As homework for you, check out the “carry forward” feature of pensions. It is particularly useful for someone who (i) predicts they will soon earn >£200k, (ii) has not been paying into their pension for the past 3 years and (iii) wants to (all but) guaranteed old millionaire status (shout out inflation!).
Wow. This took way too long to write but if you got to the end I appreciate you.
Thank you to Jake L for support with my maths and for being a great friend.
God bless,
Joseph.
This was a genuinely great read - thanks for sharing! I always learn something new.