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In the second of 4 articles focusing on people with lower incomes particularly as a result of the current recession, the Low Incomes Tax Reforms Group highlights some steps people can take to make sure they aren't paying tax when they don't need to.

Introduction

In this second article in our ‘Feeling the pinch’ series, we give some pointers on how you might be able to save tax, for example by making the most of your allowances. This article also provides links to more detailed guidance on the Low Incomes Tax Reform Group’s (LITRG) website, or other external websites such as DirectGov.  

Savings – make sure you’re not paying too much tax

When deciding what to do with your savings, it is important to take financial advice.  But here are some ideas to maximise the tax efficiency of your savings:

Individual Savings Accounts

Those who have built up some savings should consider using Individual Savings Account (ISA) limits each tax year.  For example, pensioners who have built up savings might be paying tax on the interest at 20% (or 10% if your income falls within the savings band).  By putting cash into an ISA, you can earn interest tax-free.  Each year, you can put £3,600 of cash into an ISA – this limit is per person, so couples can put in a total of £7,200.

In total, each person can invest £7,200 a year in ISAs, but only up to £3,600 can be held in cash.  You can also hold stocks and shares and other types of investment in ISAs.  More information is given in HMRC’s ISA factsheet. 

Note that in this year’s Budget, the annual investment limit for ISAs was increased to £10,200, up to £5,100 of which can be saved in cash. These higher limits will be available to people aged 50 and over from 6 October 2009 and available to all from 6 April 2010.

Getting your interest without tax taken off

If your total income for a tax year falls within your tax allowances (ie you are not a taxpayer), you can register with the bank or building society to have interest paid on your account without tax taken off.  To do this, you complete form R85 (making sure you also go through the accompanying helpsheet), also available from the bank or building society. 

When the new tax year begins, you should estimate your income for the year ahead as your eligibility to have interest paid without tax deducted might have changed – if your income has gone up you might need to start paying tax, or if your income has gone down, you might be eligible to no longer pay tax.
 
You should note that once you have completed the R85, it remains in place indefinitely – so it is always a good idea to keep a check of your income to make sure you are paying enough tax. 

R85s can be accidentally left in place where they were used on children’s savings accounts or students’ accounts and then people forget to tell the bank or building society to remove them when they start paying tax.  Another common situation for error is where a person’s spouse or partner dies and the resulting shift in their income can alter eligibility to use the R85 system. 

Making the most of your allowances

Everyone gets a personal allowance – an amount of income you can have each year before you start to pay tax.  This increases for those aged 65 or over, although this extra ‘age-related’ allowance can be withdrawn if your income is too high.
 
Couples (particularly married couples and civil partners) might want to think about how to make the most of allowances.  You each get an allowance, but it is not usually transferable to the other (note,

however, there are special rules for transferring blind person’s allowance and married couple’s allowance.
 
You can think about moving savings from one of you to the other so that the interest is paid in their name, which means it is their income for tax purposes.  You can save tax if your spouse or partner is a non-taxpayer or pays tax at a lower rate than you (for example, the 10% savings rate, on which further guidance can also be found on the HMRC website).  But there are other considerations before you move money to a spouse or partner – such as what happens to it if they die, what happens if you separate/ divorce and so forth.  

Pensions

Saving for retirement can take a lot of thinking about.  But approaching the tax year end is a good time to consider it – especially as paying pension contributions can reduce the amount of tax you pay.
 
If, for example, you are 65 or over and your age allowance is being reduced because your income is over the threshold, paying pension contributions might help.  Also, in the year you stop work and start taking your state pension, deferring claiming your state pension can reduce the amount of tax you pay on it – but there are lots of other considerations to take into account.  Read more about state pension deferral on The Pension Service website.  You can also read more about the tax consequences on the LITRG website in two earlier articles: State pension: to defer or not to defer? and State pension: to defer or not to defer? (Part 2).

Making charitable payments? Get your timing right

As with pension contributions, making donations to charity and Community Amateur Sports Clubs under the Gift Aid scheme can save you tax if you are paying at the higher rate of tax or if your age allowance is reduced because of your income level.  Mostly, any tax saving that goes with your Gift Aid payment is given in the tax year in which you made it, but if you make a payment before 31 January after the tax year end and claim on your tax return, you can have it treated as paid in the previous year. 

Example: 

Peter is 68 and self-employed.  He decides to wind up his business on 5 April 2009 and his final profits for the 2008/09 tax year are £24,000.  As he is over 65, Peter is entitled to claim a personal age allowance of £9,030, but because his income is above the abatement limit of £21,800, for every £2 his income exceeds that limit, his age allowance will be reduced by £1.  His only income from the 2009/10 tax year will be his state pension, so he will in future get the full age allowance.

Every year in June on the anniversary of his mother’s death, Peter donates £500 to Macmillan Cancer Support under Gift Aid.  He fills in his 2008/09 Self Assessment tax return in September 2009.  When he does so, he should claim for the June 2009 Gift Aid payment to be carried back to 2008/09.  By doing so, he will reduce his income for 2008/09, in turn reducing the restriction of the age allowance.
 
The numbers look slightly complicated, as the £500 Peter pays is treated as ‘net of basic rate tax’, so the deduction from his income is actually £625 (take £500, multiply by 10 and divide by 8).  He gets half of this added back to his age allowance, ie £312.50, which should save him tax at 20% of £62.50. 

Note that in order for the carry back to be used, you need to make the payment before you submit the return and claim the relief on the original return.  You cannot make a payment later and amend your tax return to claim it. 

You might therefore want to estimate your income for the current tax year to see what rate of tax you will be paying and make Gift Aid payments now. 

But watch out – there are also pitfalls.  If you do not pay tax and make a Gift Aid donation, you could be asked to pay back some tax or have your tax refund reduced.