The income tax trap for the over 65’s and how to avoid it – Money tip #149
People aged over 65 receive a higher income tax personal allowance than those aged under 65 (who have an allowance of £7,475 for 2011/12 tax year). If you are aged between 65 and 74 the first £9,940 of your income is tax free. If you are aged over 75 your annual personal allowance is £10,090.
However, the higher allowances for those over 65 start to be removed once a pensioners' income breaches £24,000 a year. Once triggered, £1 of a pensioner's allowance is taken for every £2 of income until their allowance falls to that of the under-65s.
However, from the 2010-11 tax year the Personal Allowance for people aged 65 to 74 and 75 and over can be reduced below the basic Personal Allowance where the income is above £100,000.
This removal of the personal allowance increases the person's tax bill and is referred to as the age allowance trap.
How to avoid the age allowance trap
Ways to limit the avoid the age allowance trap:
- don’t let your income exceed £24,000 for the tax year
- use tax free savings and investments such as cash ISAs, Stocks and Shares ISAs and National Savings Certificates. Theses investments can generate tax-free income.
- Couples should split their savings and investments between them to avoid each exceeding the ‘Income limit for age-related allowances’
- Use investments that generate capital gains rather than income
- Also donating to charity via Gift Aid or paying into a pension for example can extend your basic rate tax band/reduce your tax bill, even though your personal allowance may still be reduced.
Watch out for Investment Bonds
A lot of people advocate the use of Investment Bonds to mitigate the problem (you can receive 5% of the original investment amount each year tax deferred from an investment bond) without paying additional tax. It is considered a return of the original capital invested so is a useful way of mitigating income tax. (But remember Onshore bonds are taxed internally at 20% while Offshore bonds are not). Anything over the 5% annual allowance is liable to tax at your highest marginal rate.
However, while tax deferred income from bonds could be used to supplement income, if a bond is cashed in, or matures, any profit made (including the 5% withdrawals) will be added to your income in that final year. Depending on how much the profit is and how much your income is, this could wipe out any higher age-related tax allowance in the year you cash in your bond. This means that you will end up paying more tax on other income, such as your pension etc.
It doesn't matter that the investment bond chargeable gain may not give rise to an additional tax charge (due to a tax relief known as top-slicing, where the tax bill is effectively based on the average gain over the life of the policy) or that the product may not have exit penalties. Any additional tax incurred through changes to the personal allowances should be treated as a cost and factored into the decision-making process. It may be wise to phase a surrender over separate tax years or take a partial surrender to avoid this occurring.
The key point to take away is to seek professional advice before doing anything and altering your investment portfolio. Unfortuantely I’ve heard horror stories where Financial Advisers have not realised the impact of surrendering a portfolio of investment bonds on a client’s age allowance, so subsequently mis-advised the client and incurred an avoidable tax bill.
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