The new personal tax regime – maximising entitlement to personal allowances

I've spent over 30 years in tax, and after about 20 years I thought I had sorted out in my mind how the basic personal tax system worked. The introduction of the Savings Allowance and the Dividend Allowance did knock my confidence a bit but I'm now back to a state of inner calm - I think.

The question is - are you? Here's a couple of testers.

Tester 1

A client takes £11,000 from the company as salary, receives £5,500 of interest and £50,000 of dividends. What tax rates apply to total income of £66,500?

The order of taxation is earned income, then interest and then dividends. So the salary is covered by the personal allowance. Does the interest receive any benefit from the starting rate on savings income?

Go to the government website which explains the tax on savings income and you may get the wrong answer (https://www.gov.uk/apply-tax-free-interest-on-savings). It states: 'if your total taxable income is £17,000 or less you won't pay any tax on your savings income'. This is true but doesn't paint a complete picture. Total taxable income isn't defined but implies all sources of income less allowances. The £17,000 total seems to be £11,000 personal allowance, £5,000 starting rate band and £1,000 Savings Allowance.

Our total income is £66,500 so we won't get the benefit of the starting rate? Yes we will, despite the high income, because the starting rate applies if non-savings income after the personal allowance is under £5,000, and dividends are not taxed until after savings income is taxed. The personal allowance eliminates the salary leaving £5,500 of savings income to be taxed. The first £5,000 is taxed at the starting rate of 0%. The rest of the interest would be taxed at 20% were it not for the introduction of the Savings Allowance. The entitlement to the Savings Allowance is £500 as our total income exceeds the amount at which higher rate of tax applies. There is no tax on all the interest received but £5,500 of the basic rate band has been used up.

£26,500 of basic rate band remains. The tax rates applying to the dividends are:

£5,000 at 0%£21,500 (26,500 - 5,000) at 7.5%£23,500 at 32.5%

Tester 2

A client with his own company wants to minimise has tax bills on extracting profits from his company. He typically takes a salary which provides another qualifying year for his NI record but not enough to pay any NI - this is £8,060 for 2016/17. He has built up quite a lot of savings over the years by his company contributing into his pension fund. In addition, he has accumulated cash savings of £200,000 which used to be in building society savings accounts but with the continual fall in interest rates in these accounts, he has switched £100,000 of his savings into peer-to-peer websites and large company retail bonds quoted on the LSE. The £100,000 gets an average rate of interest of 5% (£5,000) and the £100,000 in building societies gives him 1.5% (£1,500). He doesn't want to pay higher rate tax on dividends from his company so a dividend of £28,440 will be paid to him. His total income is therefore £43,000. What's his tax bill?

Ok - so his salary gets taxed first but the personal allowance covers that leaving £2,940 of allowance. Interest gets taxed next and so gets the benefit of the remaining allowance which means there is the remaining interest of £3,560. This falls into the starting rate band but not all the band is utilised and he hasn't utilised his Savings Allowance.

The tax rates applying to the dividends are:

£5,000 at 0%£23,440 (28,440 - 5,000) at 7.5%

Well, that is one right answer but it's not the best one. Because less tax is payable if he exercises his right to allocate his personal allowance to minimise his tax liability. For many years the allocation of personal allowances to earned income, then savings income gave the best result and our tax software and spreadsheets have reflected this. We need to change our approach to a tax calculation in the new era:

• Compute total income to determine entitlement to the Savings Allowance. In our client's case he has £1,000 Savings Allowance.
• If non-savings income is less than the personal allowance, allocate sufficient personal allowance to remove this income from taxation i.e. £8,060 and then consider where to allocate the remaining allowance of £2,940.
• There is no point allocating the remaining personal allowance to savings income if it is going to be taxed at 0% anyway.
• But if any savings income is not going to get the benefit of a 0% rate, it will be taxed at 20% which is worse than the 7.5% applying to dividends. So only allocate in our client's case to the extent that his savings income exceeds £6,000. This means an allocation of £500, leaving £2,440 being allocated to dividends.

How much tax have you saved your client? The tax saving comes from the reduction in tax on dividends. With the reallocation of the personal allowance, another £2,440 of dividends is tax free in addition to the £5,000 Dividend Allowance. So the savings is £2,440 at 7.5% - £183. This doesn't seem an awful lot relative to the work involved but, if I was your client, I wouldn't be happy if you hadn't reallocated. Also I wouldn't be happy if I wasn't made aware of the opportunities for using the starting rate band and Savings Allowance. The maximisation of these two factors potentially saves the client £6,000 at 20% - £1,200.

Anyway, isn't it an awful lot of work? It can be which is why we have introduced our new Profit Extraction Planner. This Excel spreadsheet guides you through the complexities of the new tax regime and allows you to illustrate tax efficient options to your client. Have a look here.

It will be interesting to see if tax return software and HMRC's free tax return software automatically compute the minimum tax liability next April.