We recently met some clients who were surprised to learn that they had both exceeded their Dividend Allowance for the tax year and would need to complete a self-assessment tax return for the first time.
Having spent many years investing without having to declare tax on their dividends, these clients were somewhat confused and frustrated by this turn of events.
Unfortunately, we’re seeing an increasing number of clients being caught out by “tax drag”.
Tax drag, or “fiscal drag” refers to taxpayers being dragged into paying tax, or paying more tax, as the result of various freezes and reductions in tax allowances. According to Money Week, 1 in 5 taxpayers will start paying higher-rate tax by 2027, due to the freeze on Income Tax thresholds.
Read on to learn about how freezes and reductions in tax allowances might affect your long-term financial plan.
Income Tax thresholds have been frozen until 2027/28
Historically, tax thresholds have typically risen in line with inflation. So, in years gone by, you’d likely have needed a significant increase in your income to find yourself a higher tax band.
However, the government has frozen personal tax thresholds at their 2021/22 levels until April 2028.
The table below shows the tax rates you pay on income that falls within each band. The standard Personal Allowance is the amount of income you do not have to pay tax on. Additional-rate taxpayers are not entitled to this allowance – more on this below.
Source: UK government website
Unfortunately, these frozen allowances make it more likely that you’ll be “dragged” into a higher rate tax band if your income increases.
Indeed, the Office for Budget Responsibility has estimated that 3 million more people will pay higher-rate tax by 2028/29, and a further 400,000 will start paying the additional rate, as a result of this fiscal drag.
What’s more, if you’re a higher-rate taxpayer, you could get caught in the “60% tax trap”.
For every £2 you earn over £100,000, your Personal Allowance is reduced by £1. Once you earn £125,140 or more, you have no Personal Allowance at all. This means, that for every £100 you earn between £100,000 and £125,140, you effectively lose a total of £60 in Income Tax.
The Annual Exempt Amount for Capital Gains Tax has fallen from £12,300 to £3,000
Stealthy tax cuts to the Capital Gains Tax (CGT) Annual Exempt Amount could also drag you into paying more tax this year.
You can make a certain amount of gains on assets such as second property or non-ISA investments you dispose of in a single tax year, without paying CGT. However, this Annual Exempt Amount fell from £12,300 in 2022/23 to £6,000 in 2023/24, and then again to £3,000 for the 2024/25 tax year.
As a result of this reduction, you could see your CGT bill increase.
Imagine you invest £10,000 in an equity fund and happily see it grow to £18,000, giving you an unrealised gain of £8,000.
Had you encashed this investment in the 2022/23 tax year, you would not have paid CGT on your gain (assuming you made no other gains in the same tax year) as it would have fallen within your Annual Exempt Amount.
However, had you held on to this investment and sold it in 2024/25, £5,000 of your gain would exceed the Annual Exempt Amount and be taxable.
What’s more, the amount of CGT that you pay depends on your tax band, which could be affected by fiscal drag, as outlined above.
The Dividend Allowance has been cut from £2,000 to £500
As the amount of dividends you can earn tax-free each year has fallen from £2,000 in 2023 to £500 in 2024/25, we are seeing a growing number of people having to declare tax on the dividends they receive from their investments.
Imagine you’re a higher-rate taxpayer with an equity investment worth £50,000. If you receive a 3% dividend, you might receive £1,500 gross each tax year.
In the 2022/23 tax year, you would likely have paid no tax on your dividends as they would have been fully covered by the £2,000 allowance. Whereas in 2024/25 you would be liable to pay Dividend Tax on the £1,000 that exceeds the newly reduced allowance.
Indeed, as our clients discovered, it’s not hard to exceed the current £500 Dividend Allowance and doing so could mean that you face the time and inconvenience of having to submit a self-assessment tax return.
This can be a complicated and stressful process. Indeed, This is Money reported that HMRC could not keep up with the demand for support in completing self-assessment forms this year. As a result, many people missed the 31 January deadline and incurred a £100 fine.
What’s more, if you fail to submit within three months of the deadline, you’ll begin to incur additional daily fines, up to a maximum of £900 (2024/25).
How could you avoid fiscal drag from frozen and reduced tax allowances?
While you may not be able to completely avoid fiscal drag, a financial planner can help you mitigate the effects of the frozen and reduced tax thresholds. This might include:
Increasing your pension contributions
This could help you to reduce your taxable income and avoid moving into a higher tax band or falling prey to the 60% tax trap. Using salary sacrifice to make additional pension contributions and to reduce your salary below £100,000 can help you to retain your Personal Allowance and reduce your tax liability.
Making use of your full annual ISA allowance
You can put up to £20,000 into ISAs each tax year (2024/25). There’s no tax charged on the dividends you receive and any profits from investments are free of CGT.
Planning your finances as a couple
By making full use of your individual tax allowances, you could save more efficiently as a couple.
For example, you could also ensure that taxable dividends are paid in the name of the spouse who pays the lowest taxes to reduce the amount of Dividend Tax you’ll pay as a couple.
Additionally, gifting assets to your spouse or partner could allow you to effectively double the CGT Annual Exempt Amount that you have as a couple and potentially reduce your combined CGT bill.
Get in touch
To find out more about how we can help you build your wealth tax-efficiently, please get in touch. Email hello@sovereign-ifa.co.uk or call us on 01454 416653.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
