Tax Planning - Reduce Your Tax Bill

Here are the answers to some frequently asked questions about tax planning strategies. Where do I start? The best place to start is with the three main personal allowances and exemptions. For the 2003/04 tax year, each member of your family has an income tax annual personal allowance of £4,615; a capital gains tax annual exemption of £7,900; and an inheritance tax annual exemption for gifts of £3,000.

How can I save income tax?

Your personal allowance is the amount you can receive before paying income tax. The source is irrelevant – it can be earned income or investment income.

One of the best ways to save on income tax is to share income, making use of a non-working or lower-earning spouse’s personal allowance. The most common redistribution techniques are to give income-generating assets to your spouse and, if you run your own business, to pay your spouse a salary. This could lead to an overall annual saving of thousands.

What about the children?

It is possible to give your children income-producing assets to make use of their allowances and, where necessary, their lower and basic rates of taxation. However, you may need to set up a trust so that the income is not classed as your own. Generally, if the annual income from your gift is more than £100 per annum, you, as the parents, will be taxed on the entire amount.

You can set up a bare trust to hold the assets and avoid paying the tax. This makes the parents the registered owners who hold the assets in trust as nominees for the children. The income is accumulated until the children are 18. Where the gift is from another family member – grandparents for example – income generated is classed as the children’s own and can be offset against the personal allowance.

How can I avoid having to pay Inheritance Tax (IHT)?

There are several ways to mitigate your inheritance tax bill. Each year you can give away up to £3,000 free of IHT. Another under-used exemption is modest gifts from income. These are gifts that the Inland Revenue describes as normal or habitual and leave sufficient income for the donor to maintain his or her standard of living. If you have enough spare income, there is nothing to stop you paying regular amounts to a son or daughter.

There are several other useful IHT exemptions. For example, if your children get married, you can give them each £5,000 while other relatives can give up to £2,500 free of any IHT liability.

Can I give away large amounts to reduce a tax liability?

In practice, there is nothing to stop you giving away any amount in excess of the £255,000 IHT exemption, but if this is a substantial gift – a house for example – if you die within seven years, the tax assessment is based on when you made the gift and the date of death. A sliding scale of tax rates are used if the gift is in excess of the nil rate band, so the longer the period between the two dates, the lower the liability. This arrangement is known as a potentially exempt transfer.

How do I avoid my kids having to pay a big IHT bill?

One option worth considering if you anticipate a large IHT liability is to take out a life assurance policy that will cover the costs when you die. A joint life, second death, whole-of-life policy is often used for this purpose. It should be written in trust for the successors (the children, for example) to make sure the policy does not form part of your taxable estate on death. A ‘Flexible Trust’ arrangement would typically used for this purpose.