Personal Tax

Income Tax, Capital Gains Tax and Inheritance Tax are the three main taxes that you or your estate face. This guide shows how these taxes are collected and explains what tax rates you are likely to find yourself paying.

• How much tax am I paying?
• Why do we pay Income Tax?
• Are interest and dividends taxed as income?
• What is Capital Gains Tax?
• How does Capital Gains Tax work?
• Can I avoid Inheritance Tax?
• What is exempt from Inheritance Tax?

How much tax am I paying?

There is no such thing as Government money! What the Government spends is money that it has either borrowed in the financial markets or raised through taxation. When you fill out your self-assessment tax form - or collect your pay packet and see all the deductions for tax and national insurance - it might seem that you spend more time at work earning money for the Government than for yourself. That's not quite true but only just.

According to economic think-tank the Adam Smith Institute, adding up all the tax the average taxpayer pays every year would be the equivalent to working solidly for the government from New Year's Day until around the end of May. The day when you start to earn money that goes into your own pockets, rather than that of the Chancellor, is aptly named, Tax Freedom day. Budget 2008 moved Tax Freedom Day back 24 hours to 2 June so this year we're all working an extra day for the Government.

Tax is rather like dentistry. It is something most of us approach with trepidation. But the simple fact is that most of us pay more tax than we have to and we need help to navigate the tax maze. Paying tax may be a legal requirement but it is not a moral one.

Do you work for your money or would you prefer to make your money work for you? Efficient tax planning is the key to maximising your wealth. The economist John Maynard Keynes said, "The avoidance of taxes is the only intellectual pursuit that still carries any reward."

You can find full details of all the various tax rates and allowances on Moneyextra's Tax Tables .

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Why do we pay Income Tax?

Income Tax was introduced in the UK originally as an emergency measure in 1798 to fund the war against Revolutionary France. Income Tax is charged on all income arising in the UK. An additional complication is that UK residents may also be liable for Income Tax on income arising from overseas sources, dependent upon individual circumstances.

Personal allowances are deducted from income before calculating Income Tax. Additional allowances such as age-related personal allowance and age-related married couples allowance may also help to reduce the Income Tax payable.

Married couples are treated as individuals for the purpose of Income Tax, and have their own allowances and rates. For 2008 / 09, the basic personal allowance is £5,435. This is how much you can earn in the tax year before you start to pay Income Tax.

Income Tax is a progressive or graduated tax - it increases as a percentage of income as your income gets larger. The lower rate tax band of 10% was scrapped in Budget 2008. Income Tax is now payable in just two bands. The Basic Rate of Income Tax, payable at 20%, is charged on taxable earnings up to £36,000. Earn over this £36,000 threshold and you will pay Income Tax at the Higher Rate of 40% but remember this rate will apply only to the portion of taxable income over £36,000 - any earnings under this will still be charged at 20%.

You don't have to like tax but you do have to pay it. But are you paying too much? See if Moneyextra's Tax Centre can help tackle your tax bill.

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Are interest and dividends taxed as income?

Most investment income is taxed at 20% when your total income, minus allowances and reliefs, is not more than the Basic Rate limit, which is currently £36,000 (tax year 2008 / 09). Exceptions are dividends from UK companies and rents. If your income exceeds £36,000 (over and above your personal allowance) then you are a higher rate taxpayer and will have to pay 40% tax on that part of your gross investment income which is above the basic rate limit.

There is a 10% starting rate for savings income, with a limit of £2,320. If an individual's taxable non-savings income is above this limit then the 10% rate does not apply. Otherwise, savings income is received after 20% tax has been deducted at source. If you are a Basic Rate taxpayer then you will have no more tax to pay. If you are a higher rate taxpayer you will be liable to pay a further 20% of gross income above the basic rate limit. If you are a non-taxpayer you may opt to have the interest on your savings paid to you gross.

Taxed savings income includes bank and building society interest, annuities, and interest on Government stocks if you choose. Untaxed savings income includes most National Savings Bank income and interest on Government stocks.

UK and foreign dividends form the top-slice of taxable income, which means you face tax on such dividends at your highest rate of taxation. Such dividend income could push you into the higher rate tax bracket. UK dividends are paid with a 10% tax credit. If your total income falls within the lower rate or basic rate limit there is no further tax liability. However, higher rate taxpayers are liable to tax at 32.5% on that part of the dividend falling above the higher rate limit. For non-taxpayers the 10% tax credit is not reclaimable.

As with all other forms of taxation and allowances, the right professional advice can help you maximise your tax efficiency and enhance your wealth.

Go to Moneyextra's Tax Centre now .

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What is Capital Gains Tax?

One anonymous wag once suggested that, while a fine is a tax for doing something wrong, tax is a fine for doing something right! He (or she) was probably thinking of Capital Gains Tax (CGT ). When you sell a possession (or in the jargon dispose of an asset) you are potentially liable for Capital Gains Tax. Normally the method of disposal is a sale, but it may also be compensation for loss or damage to the asset or a gift. Some windfall payments are also included.

The first £9,600 of your 'net gain' during the 2008 / 09 tax year is free of CGT. Any gain you make over this amount will be taxed at a flat rate of 18% unless you are eligible for entrepreneurs relief in which case you would pay tax on your gain at a rate of 10%.

No CGT is payable on death (this doesn't mean you / your estate get off scot-free, there's still the little matter of Inheritance Tax).

Want to know more about the way you are being taxed? Check out Moneyextra's Tax Tables.

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How does Capital Gains Tax work?

First of all, gains on certain assets are free of Capital Gains Tax (CGT). They include:

• Your main residence
• Government securities
• Qualifying corporate bonds
• National savings certificates
• Individual Savings Accounts (ISAs)
• Personal Equity Plans (PEPs)
• Life assurance policies
• Betting and lottery wins
• Compensation or damage awards

Gains above the nil rate on other assets will be chargeable at the flat rate of 18% unless they qualify for entrepreneur's relief, which may be available in respect of gains made on the disposal of:

• All or part of a trading business the individual carries on alone or in partnership;
• Assets of the individual's or partnership's trading business following the cessation of the business;
• Shares in (and securities of) the individual's "personal" trading company (or holding company of a trading group);
• Assets owned by the individual and used by his / her "personal" trading company (or group) or trading partnership.

The first £1 million of gains that qualify for relief will be charged to CGT at an effective rate of 10%. Gains in excess of £1 million will be charged to CGT at the rate of 18%. Claims for entrepreneurs' relief on qualifying gains may be made on more than one occasion up to a 'lifetime' limit of £1 million.

Trustees will be able to claim relief on certain disposals of business assets and company shares and securities where a "qualifying beneficiary" has a qualifying interest in the business in question. Trustees must make claims jointly with the "qualifying beneficiary". Any relief given on the trustees' gains will reduce a beneficiarys £1 million lifetime limit on relief.

Plan a sound financial future right now with our cutting edge online financial planner.

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Can I avoid Inheritance Tax?

Death and taxes may both be inevitable but there is no reason why they should go hand in hand. Nevertheless, all of us may face an Inheritance Tax ( IHT ) liability if the value of our estate on death exceeds £312,000 (tax year 2008 / 09).

The nil rate band may also be carried over between married couples and those in a civil partnership - giving the surviving partner a total IHT-free allowance of £624,000. This means that when the estate is passed to their beneficiaries, say children, the first £624,000 is IHT-exempt rather than the first £312,000. So on a mortgage-free £700,000 estate, IHT would only be payable on £76,000.

Remember, even all those things that were exempt from Income Tax or Capital Gains Tax during your lifetime (your home, your ISAs, etc.) will be taken into account in calculating the total value of your estate.

In fact, taking into consideration the strong growth in property prices in recent years, many of us will now face an IHT problem as the value of the family home may easily, by itself, exceed the £312,000 nil rate limit.

Estates over £312,000 will attract tax at 40%. For example if your estate is worth £412,000 your tax liability will be 40% of £100,000 (the difference between the nil rate band of £312,000 and the total value of the estate) and your estate's tax bill would be £40,000.

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What is exempt from Inheritance Tax?

Certain gifts that you make are exempt from Inheritance Tax considerations. You will not be surprised to learn that any gifts to major political parties are exempt. However, there are other potential recipients of your largesse that will help reduce your estate's IHT liability. All gifts to charities and various public institutions are exempt as are gifts or transfers of assets between husband and wife, providing that you both are UK domiciled.

In addition there is an annual exemption of £3,000 per annum. To the extent that this is not used in one tax year, it may be carried forward to the following tax year. You also have a small gifts exemption of £250 per annum. You may make any number of such gifts to different individuals in a tax year. What you cannot do is make more than one such gift to the same individual. Do so and the total counts as one gift - if the value exceeds £250, then the exemption would not apply.

Certain gifts in consideration of marriage are exempt. You may gift up to £5,000 to your children, £2,500 to your grandchildren and £1,000 to anyone else. Normal gifts out of income are also exempt. The gifts must be regular, out of after-tax income, and must not reduce your capital taking one year with another.

On top of these various exemptions come the most important IHT get-out clauses, the potentially exempt transfers, which apply to any gifts you make above the exemption limits already discussed. Providing you survive seven years from the date of your gift, this gift will be exempt from IHT. If a gift becomes chargeable because of your death within seven years, then, in some instances, taper relief may reduce the tax payable.

Be aware that if you gift an asset but retain the benefit it may be treated as still forming part of your estate on death. If you made a gift of property but continued to live in it rent-free or retained a benefit then you may face an Income Tax charge on an annual basis on the benefit you are receiving and the property may still qualify for IHT.

However, all these exemptions involve giving something away and reduce any income and capital you have, whether it be for a rainy day, pleasure or any future financial needs. Whatever your age there are steps you may take to help reduce the amount the taxman can claim when you die.

Expert and efficient tax planning together with professional independent financial advice is the answer. Budget 2006 imposed a new tax regime on many trusts that had previously been used to mitigate the impact of or avoid IHT liabilities entirely. In addition, rulings by the Special Commissioners, the panel that adjudicates tax law, have also had an impact on how trusts are affected by IHT. If you have trust arrangements in place or are considering using them it is vitally important that you take independent financial advice to make sure they are still tax efficient.

Through the proper organisation of your affairs, together with independent financial advice, it can be easier than you may think to mitigate your IHT liability while retaining control of your assets.

Do you need unbiased independent financial advice? Why not give us a call?

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26 March 2008 © Moneyextra.com

Our senior editor Robin Amlôt recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.