What will frozen tax bands mean for personal finances?

30 Apr 2021

calculator and paperwork

On the surface, the Budget announcements were less controversial than many had anticipated and we will now have to wait and see what the Chancellor’s Autumn statement brings. However, with a focus on freezing tax bands rather than increasing tax rates, how do we quantify the real term impact for individuals? In this article we take a closer look at this and the associated impact on government revenue over the next few years.

Income tax

As a reminder:

  • From 6 April 2021, for residents of England and Northern Ireland, the income tax basic rate limit increased to £37,700, the higher rate threshold to £50,270 and the personal allowance went up to £12,570. These limits are now frozen until April 2026, in a process known as ‘fiscal drag’.
  • The effect of the freezing is quite dramatic, with the Office for Budget Responsibility (OBR) estimating that they will bring a further 1.3 million people into the tax system and 1 million into the higher rate tax band.
  • By way of example, an individual currently earning £50,000 will not currently be paying any tax at the 40% rate, however over the next few years, even a modest inflationary pay rise, compounded over the period to April 2026, will push them into the higher rate tax band.
  • In fact, at almost every level, a larger proportion of an individual’s earnings will now be spent on tax.
  • OBR figures suggest that the result is that income tax receipts via pay as you earn and self assessment will be £54.2 billion higher by 2025-26, compared to in 2019-20.
  • The income tax rates and bands (but not the personal allowance) are devolved to both the Scottish and Welsh governments.
  • The Welsh income tax rates and bands are currently following those for England and Northern Ireland and the Welsh government has committed to hold the rates for the period of the current Senedd.
  • In Scotland, the income tax rates follow a more progressive pattern with a higher threshold of only £43,662, due to increases in recent years being restricted to inflation. There has been no government commitment to holding the rates, although the recent SNP manifesto has pledged to do so, with others also suggesting they would not increase the rates.

Inheritance tax

  • Similarly, the inheritance tax (IHT) nil rate band of £325,000 and residence nil rate band of £175,000 have been frozen until April 2026. These are the amounts that can pass tax free on death, with the excess being charged to IHT at 40%.
  • Freezing the thresholds rather than increasing them with inflation means that a higher proportion of estates will be subject to IHT at 40%. The nil rate band has not changed since 2009, meaning that this freeze only exasperates an existing issue.
  • OBR figures suggest that by April 2026, the government could be raising an additional £1.5 billion in IHT, compared to 2019-20.

Capital gains tax

  • The capital gains tax (CGT) annual exempt amount will also remain at its current level of £12,300 until April 2026.
  • CGT is generally payable when an individual disposes of an asset and the profit exceeds their annual exempt amount.
  • Freezing this allowance, rather than increasing it with inflation, means that a greater number of disposals are likely to fall into the CGT net.
  • Again, the OBR has put some figures to this which suggest that revenue from CGT will rise by not far short of 50% from £9.8 billion in 2019-20 to £14.4 billion by 2025-26.

Pensions

  • On the pensions front, the Lifetime Allowance of £1,073,100 will be frozen, again until April 2026.
  • With the effect of inflation, the amount an individual will be able to put into pensions with the benefit of the associated tax savings will be lower in real terms than it is currently.
  • To counteract this, individuals may wish to consider alternative savings options to supplement their pension savings, eg a Lifetime ISA, where individuals aged up to 50 can contribute up to £4,000 per year with the government topping it up by 25%. If the maximum contributions are made from age 18 to 50, this could add up to £160,000 to an individual’s retirement funds.

Corporation tax

  • From April 2023 the main rate of corporation tax will increase to 25%, with a small profits rate of 19% for profits not exceeding £50,000. There will be marginal relief for profits between £50,000 and £250,000.
  • Whilst smaller family run trading companies are unlikely to suffer the full 25% rate, close investment-holding companies, including many family investment companies, will not qualify for the 19% rate, regardless of their profit level.
  • An additional 6% tax could make profit extraction noticeably more expensive. For illustrative purposes, approximately £19,500 of profit will be required for a higher rate shareholder to receive net dividends of £10,000 after corporation and income tax, compared with £18,000 under current rates.
  • OBR figures suggest that the changes to corporation tax will progressively increase government revenue, with additional receipts reaching £16.4 billion in 2025-26.

Summary

The impact of the Budget may not be felt by individuals immediately. However, the government is set to generate significant additional revenue over the next few years in an attempt to address the economic impact of the Coronavirus pandemic. Individuals should therefore be prepared for the inevitable pinch on their disposable income.

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