Episode 349 - On this week's show I explain the '60% tax trap', giving two examples of where it can occur and what you can do to mitigate it. I also reveal the optimum asset mix when investing throughout a pandemic, designed to ride the waves as news of vaccines and a number of new variants impacts investing markets. Finally, Andy provides a roundup of the latest scams including what you can do to avoid becoming a victim.
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Abridged transcript - Episode 349
Damien Fahy 3:08
There are three pieces on the show this week as usual. Firstly I’m going to explain what the 60% income tax trap is because it impacts more than just wealthy people. There are two occasions where you can get caught by it, so quite a few listeners will be being caught by the 60% tax trap even if they're not aware of it. I also want to explain what you can do to avoid and mitigate it. The other thing I want to talk about is a bit of investment research that was inspired by something I did for 80-20 Investor. I want to talk about the best asset mix for a portfolio for the pandemic, so looking back over the two years of the pandemic right up until now, when we discovered the new Omicron variant. There are lots of rotations in markets backwards and forwards and I want to look at whether there was a consistent asset mix that would have been good for the COVID pandemic. Then Andy will be doing the last piece regarding scams.
Andy Leeks 4:44
It's that time of year unfortunately when some of these scams are coming to a head and lots of national newspapers are reporting on various types of scams. So I've brought them all together and I'm going to reveal three or four of the most popular scams at the moment and how you can avoid becoming a victim this Christmas.
60% Income Tax Traps
Damien Fahy 5:20
The 60% income tax trap occurs on two occasions. You may have heard of it in relation to people who earn over £100,000 a year who can start to be taxed at an effective income tax rate of 60%, but there are things you can do to mitigate that.
But there are people who will also earn a lot less, who can also be hit by an effective 60% income tax charge. More than half a million people are impacted by the effective 60% income tax trap. That means thereare going to be quite a few people listening to this podcast that have been impacted.
The 58.2% tax trap that hits those with children
I'm going to start with the most likely way that listeners are getting hit by an almost 60% tax charge. If you've got children and you’re claiming Child Benefit, then if you earn over £50,000 or your partner does, then you are potentially liable to a tax charge called the High Income Child Benefit Tax Charge. What that means is that for every £100 that you earn over £50,000, then you lose 1% of your Child Benefit and it has to be paid back as a tax charge.
So what typically happens is somebody is claiming Child Benefit, then by the time they hit £60,000, then they will have to pay it all back via their self-assessment tax return.
There are many people who don't realize this; they might get a pay rise or a bonus that tips them over the £50,000 threshold and therefore they have to pay this High Income Child Benefit Tax Charge. I want to give you an example as to why it works out to be an effective 60% income tax charge.
Imagine if you have two children and you claim Child Benefit for them. For the first child you'll get £21.15 a week and for the second child you currently get £14 a week. Multiply that by 52 and that equates to £1827.80 that you receive in Child Benefit a year. Now, let's say you earn £1,000 over the £50,000 threshold, then what it means is that you lose 1/10 of your Child Benefit, which is going to have to be paid back as a tax charge. That obviously equates to £182, rounding it down. Then don't forget, in addition to that, you're going to start being charged income tax at 40% on anything that you earn over £50,270, which is the lower boundary of the 40% income tax band.
So just for ease because it makes it simple for people listening to this podcast, I’ll round that down to £50,000. So as you start earning money above the £50,000 threshold, you are going to start having a tax charge but you are also going to be paying more income tax. So let's say for argument's sake, that you earn £1,000 above the £50,000 threshold, then you're going to pay £182 in the High Income Child Benefit Tax Charge plus £400 in income tax which if you add it together is £582, which equates to a 58.2% effective income tax rate.
Obviously the actual band for income tax at 40% is £50,270 (and not £50,000), but you get my point, if you keep earning money above that all the way up to £60,000, then you are paying effectively a 58.2% tax charge. Or in other words almost 60%.
The 60% income tax trap that hits those earning over £100,000
The other time you pay an effective 60% income tax rate is if you earn between £100,000 and £125,000. And again, it could be that you get a bonus that takes you over that £100,000 threshold.
If you earn over £100,000 you pay a 60% effective income tax rate because your tax-free personal allowance goes down by £1 for every £2 that your adjusted net income is over £100,000. So that means that you have no personal allowance if you earn £125,140 or above. Don’t forget that your personal allowance is the amount of income you can earn which is tax-free. The current personal allowance is £12,570.
If, for example, you earn £101,000, then you've gone £1,000 over the £100,000 threshold. On the additional £1,000, you're, of course, paying 40% income tax anyway (which equates to £400), but you've also lost £500 of your personal allowance, as you lose £1 for every £2 over £100,000 that you earn.
That means an additional £500 of your money is taxed at 40%, which obviously equates to £200. So if you add the £400 and the £200 together, you get £600 tax that is effectively paid on that additional £1,000 that you've earned above the £100,000 threshold. That means you are paying an effective 60% income tax rate.
How to avoid the 58.2% income tax trap if you earn over £50,000
The key is what counts as ‘adjusted net income’ as that is actually what determines whether you lose your Child Benefit or personal allowance.
Adjusted income is defined as your total taxable income before personal allowances and less items such as Gift Aid. So if you had taxable income of £60,000, then you'd lose all of your Child Benefit. But something else that can reduce your adjusted net income are gross pension contributions. So if you had a taxable income of £60,000 income and you paid a net contribution of £8,000 into a pension this will be grossed up to £10,000, by your pension provider automatically as it claims basic rate tax relief of 20% on your behalf, which means that your adjusted net income is £50,000. This would mean that you keep your full Child Benefit entitlement.
Bear in mind that money put into a pension can't currently be accessed until age 55. Also don't forget that you will be able to claim back tax relief at 40% on any pension contribution. So your pension provider will have already claimed 20% tax relief for you straight away when you paid the £8,000 into the pension. The pension provider automatically adds this to your pension to make it £10,000, but you can claim the extra 20% tax relief via your tax return.
So making pension contributions is one way to mitigate losing your Child Benefit and avoid the 58.2% income tax trap.
Another way to avoid losing your Child Benefit is to split your earnings, if you can, across tax years. That way you’ll be able to mitigate the amount you earn in a given year.
Or you could try and shift your income in some way. Let's say you had income-producing investments, you might be better off putting them in your partner's name. Because somewhat unfairly, a couple can earn almost £100,000 (e.g. £99,998) but split it down the middle so that they each earned just under £50,000 and they would keep their Child Benefit. But a couple where one of them wasn't earning anything and the other person earned £60,000 would lose all of their Child Benefit.
It is an unfair system, but they are the rules. So you could try to mitigate losing your Child Benefit by moving income assets around.
The other thing you can do is salary sacrifice, where you give up a portion of your salary in exchange, for example, a pension contribution. And that will not only help mitigate the tax charge for the Child Benefit, but you also save on national insurance, as can your employer.
Now, I'm not going to dwell on salary sacrifice, because there are pros and cons but go back and listen to podcast 85 where I talk about it. But also podcast 339, where I talk about bonus sacrifice, again with the pros and cons.
Another way to mitigate losing your Child Benefit is to make gifts to charity, as it helps reduce your adjusted net income.
How to avoid the 60% income tax trap if you earn over £100,000
So moving on to the scenario where you earn over £100,000, and you start to lose your personal allowance, how you mitigate that is basically the same way as you would mitigate the High Income Child Benefit Tax Charge as mentioned above.
So you could make pension contributions. So somebody who was earning over £125,000 could put in a large pension contribution to bring their adjusted net income under the £100,000 threshold and therefore keep their personal allowance. Again, there are pros and cons to doing this. But for people who earn that amount of money, they also could be interested in carrying forward unused pension contribution allowances from the previous three tax years. So that's an additional £120,000 worth of pension contributions they can pay on top of the £40,000 they could pay in the current tax year, which they could therefore be used to bring down their adjusted net income. But not only that, because it's a sizable number, some people do use it to reduce their tax bill more widely, because if you earn over £150,000, you are into the 45% income tax bracket. But I'm not going to go into too much detail here. If you want to carry forward pension contributions you have to have been a member of a pension scheme as far back as you want to be able to carry the unused allowances from. But you must also have high enough earnings in the current tax year to be able to have paid the income tax you wish to reclaim. The upshot is that if you made a pension contribution of £160,000 in total, then someone who's a 45% taxpayer could claim up to £72,000 in tax relief.
Optimum pandemic asset mix
Damien Fahy 16:18
This part of the podcast was based upon a research article I produced for 80-20 Investor members, called 'Finding a Covid core'.
Andy Leeks 23:12
I’m now going to talk about scams.
1 - The first one I'm going to cover off is the "child in need" scam where fraudsters trick money out of parents by posing as one of their children. They fire off thousands of messages to numbers that they've harvested with a fairly simple message saying something like, “Hi Mum/Dad, I've lost my phone. This is my new number, can you text me back.” It's normally via WhatsApp that this is created and then a conversation starts. They gain trust and they try to make it look like one of your children is stuck; they've lost their phone. It's an introduction to try and wire some money over to them via banking. It’s unsophisticated but it can be very convincing and very easy if you have got a child that's often losing their phone or if you're worried about them because they'd been going out to a party or traveling and they’re asking for money. If you receive one of these messages, you don't want to assume they're a scammer as it could actually be your child in need, so you can use code words that you set up beforehand or ask them to send a voice message if it’s via Whatsapp as you're going to be able to recognize their voice. You could ask them a question e.g. “What's your middle name?”, “What's your date of birth?” or something else as an extra layer of security. Just make sure that the person who's at the other end of that message is the person you think it is.
2 - Another popular scam, especially around Christmas time, is the “You've received a parcel” or “We've missed your delivery” text purporting to be from courier companies like DPD, Yodel, Hermes. Because you don't know what those numbers are, a random number could seem very genuine, especially if you're expecting a parcel. If you're being asked to click a link where you're asked to provide more information, be very wary. None of these delivery firms would be asking for extra information; they've got your address, they've got your phone number so don't be tricked into giving extra information. This type of scam is a way of harvesting extra information. What will tend to happen is you'll then receive a phone call pretending to be from your bank saying, “It looks like you've submitted some additional information on a scam text. We're from your bank and we're going to protect you by asking you to move the money into a safe account. Now, of course, they're actually the scammers. Just be careful of that; don't fill in any information. If you think that you've missed a delivery, then go into where you originally placed the order, check your emails, go into the website that you ordered from and check that way.
3 - The cash trap scam. This is where there's a device fitted to the actual cash point and it's very difficult to see. It effectively blocks off the cash from being able to dispense. So you put in your card, you put in your number and you select how much you want, your card is returned and there's a message on screen saying to take your money, but the money doesn’t arrive. There'll be a cash trap that the scammer has fitted to where the money is dispensed. You then assume that there’s something wrong with the cash machine so you walk off and probably contact your bank to report a problem with the cash point. There will often be a scammer hiding around the corner who will nip up to the cash point, prise the trap away and take the money before resetting the trap for the next person.
4 - There are a lot of scam emails that you'll receive and you'll see them come through and you'll think that doesn't quite look right. Make sure that you don't click the ‘unsubscribe’ button on those emails; the best thing to do is if you think something is a scam email is to delete it, but before you delete it, mark it as spam and then your email should start to filter those out. Don't be tempted to click the ‘unsubscribe’ button at the bottom of those emails as you're effectively telling the scammer that you're a real human being and it will actually increase the amount of scam emails you get sent because your details will then be sold on through the dark web and it will spiral.