📝 Table of Contents
Introduction
- Why do I pay so much tax?
- The importance of tax reliefs and allowances
Understanding the UK Tax System
- How your tax bill is calculated
- The bracketed tax system
- Common misconceptions about tax in the UK
Ways to Reduce Your Tax Bill
- The benefits of a pension
- Running your own company
- Investing in an ISA
- Lifetime ISA (LISA)
Conclusion
- Reducing your tax bill
- Do your own research
📝 Introduction
If you're based in the UK and have at least one form of income, then you've probably asked yourself at some point, "Why do I pay so much tax?" In a bid to reduce the country's huge deficit over the past number of years, this question has probably been asked more and more frequently as the government has steadily increased tax rates. That has been a real bitter pill to swallow, especially with the cost of living in the UK becoming more and more expensive. So, in times like these, it's crucial that you act smart and use whatever means you can in the form of tax reliefs and allowances to protect your income and ensure that you're not paying the tax man any more than is necessary. Understanding the different ways that you can reduce your tax bill is a real challenge to some because it can actually be quite complex. In fact, it's estimated that the majority of people in the UK are not making full use of their tax allowances and exemptions, and as a result of that, around 12 and a half billion of extra tax is being paid cumulatively each year. As somebody that has faced huge tax bills in the past, I have done my fair share of research into the different allowances that we are entitled to each year. So, in this article, I'm going to be summarizing the ones that I think are going to be most relevant to you guys so that hopefully, you can reduce the amount of tax that you pay.
Why do I pay so much tax?
With the top bracket of income tax currently sitting at 45 percent, tax is likely to be the biggest expense that you'll ever pay throughout your lifetime. Learning how to reduce that bill is going to be the easiest way to make your money go further. But before I cover the different ways that you can legally reduce the tax that you owe on your income, let's just run through how your tax bill is actually calculated in the first place, and that is going to help you understand how reliefs and allowances will actually help you out.
The importance of tax reliefs and allowances
Within the UK, every single person that earns income, which includes salaries, bonuses, rental income, and pensions, they pay nothing on their first 12,570 pounds of annual earnings. So, your personal allowance. Above that, they pay income tax with the effective rate that is charged set according to the amount that you're getting paid and the number of tax brackets that the size of your income fits into. Now, in the UK, we use a bracketed tax system with different tax rates applying to each tax bracket. So, you start off with the basic rate 20, then you move to the higher rate 40 percent, and then the additional rate 45. A common misconception that many people have about tax in the UK is that as soon as your earnings reach the size of the next tax bracket up, you'll pay a higher rate of tax on your entire income. So, you'd actually be earning less than before if you got a pay rise. But that is simply not true because the UK's tax system is a progressive one, and that means that if you get a pay rise to earn, say, 60,000 pounds, you'll still continue to be charged 20 percent tax. So, the basic rate amount on earnings up to 50,270, with just the remaining ten thousand pounds or so attracting that higher tax rate of 40 percent. If you've been offered a pay rise at work that's going to put you into the higher rate 40 percent tax bracket, and you're questioning whether your net earnings will actually go down because you're now paying a higher rate, just remember it's only the income that sits above the bracket that you're in, which is currently for basic rate payers fifty thousand two hundred and seventy, where you will pay the incremental amount. So, forty percent. Now, if your income is higher than 100K a year, then there is a slight nuance to the effective tax rate that you pay because for every two pounds you earn above this amount, you lose one pound of your twelve and a half thousand personal allowance. But with that said, that's not going to impact the majority of the guidance that I'm sharing with you today. So, we'll save diving into the detail of that for another day.
Understanding the UK Tax System
Now that you understand that the UK's tax system is a progressive one that uses tax brackets, let's run through the different ways that you can reduce the amount of tax.
The benefits of a pension
For pretty much all of my 20s, I couldn't think of anything more boring than pensions. I viewed them as something that only old people should care and think about, and because of that, I never bothered to learn what they actually were, which meant that I missed out on years of tax savings. So, don't make the mistake that I did and just spend a moment now listening to what a pension is from me and why they are so beneficial to have. In its simplest terms, a pension is just like a savings account that you deposit into, with the only difference being that you can't touch those savings until you retire from work, which is likely to be in your 60s. Every employer in the UK has to offer and arrange a workplace pension for you by law, with the amount that you choose to save into that pension deducted each month from your paycheck before any taxes have been applied. So, if you earn 50,000 pounds a year and you tell your employer that you want to contribute 10 percent of your earnings into your pension, then five thousand pounds is going to be put into your pension account, and it won't be taxed. Over the years, that five thousand pounds and any other contributions that you make is hopefully going to grow substantially because it's not just sitting as cash in your pension's bank account, but it's invested into stocks and shares and managed by an investment manager whose one goal is to grow that pot as much as possible. Once you retire, you can then pay yourself 25 percent of whatever is in that pot completely tax-free. To make this deal even sweeter, most employers will match or even beat whatever you contribute into your pension every single month, and that's again at no tax cost to you. So, you deciding to contribute 10 percent of your salary every year into your pension that is not only going to increase your effective earnings by the amount of tax that you've avoided paying but also by the amount that your employer is contributing to your pension as a result of its match scheme. The downside, of course, to pensions is that you can't touch that money until you're at least 55, but it is still well worth doing because it's free money, and you're helping to secure your quality of life when you're older by contributing a relatively small amount today. If you're self-employed or you have your own business, then don't worry, you're not going to be left out when it comes to pension benefits because any contribution that you make for your company that is an allowable expense, i.e., you won't pay any tax on whatever you decide to put straight into your pension.
Running your own company
Speaking of having your own business, that leads me on to my next tip for reducing your liability, which is creating your own company. If you own your own business or you have a side hustle or you're thinking of having one, then one of the easiest ways to reduce how much tax you legally pay is to run that business or side hustle through a company. Every business that I own, so my Amazon FBA business, my coaching business, YouTube business, and so on, each of those is operated through limited companies, and that's because of the tax allowances and reliefs that are given to companies instead of individuals. As a company, you're able to deduct business-related expenses from your income, and that reduces the tax that you owe to the tax man. For example, for my businesses, I've had expenditure on items such as my camera, my computer, even a portion of my electricity and heating bills. All of those have been used to lower my tax bill. Additional business-rated expenses that you'd be permitted to incur would include things like lease costs from renting a car, fuel costs, and even courses and private coaching from a mentor provided that the expense was incurred for the purpose of running your business. It should technically be allowed. If you're unsure or need additional guidance on what is and isn't permitted to be used to lower your tax bill, speak with your accountant. And if you don't have one or if you need one, go with my recommendation, which is awesome, who are a digital accountancy firm.
Another huge advantage of operating your business or your side hustle as a company is that the actual tax rate that is applied to your profits is lower than if you were to just operate as an individual. In the UK, businesses pay a 19 percent corporate tax rate, and that is applied to profits after all expenses. If you then want to withdraw the profits from your company via a dividend, you'll get the first a thousand pounds tax-free, and then after that, if you're a basic rate taxpayer, you'll pay 8.75 percent dividend tax. And that compares to 20 percent income tax on top of 13.8 percent National Insurance contributions if you are running your business as an individual. So, if you want to run a business or you already have one, do it through a limited company. Your future self will thank you when it's calculating your tax liability.
Investing in an ISA
In the UK, one of the easiest ways to pay less tax and even get free money from the government is by putting any savings that you have into a special type of savings account known as an individual savings account, also known as an ISA. An ISA is essentially an investment account that you can save up to twenty thousand pounds a year into, and that amount is shielded from any tax charges whatsoever. So, if your ISA balance increases in size, whether that be due to interest payments on your cash or dividend payments or Capital Growth if you're invested into stocks and shares, then guess what? You won't pay a penny in taxes. For example, if you manage to save say twenty thousand pounds into an ISA that's paying five percent interest, after a year, you'll have made one thousand pounds worth of tax-free interest income. Awesome. To encourage young people to save as much as possible, the government also offers something known as a lifetime ISA or LISA, and that has a 4,000 pounds annual limit and comes with a 25 percent cashback bonus for free. So, if you save four thousand pounds a year into one of these accounts, at the end of each year, you'll automatically be given an additional one thousand pounds tax-free on top of any interest or dividend payments earned. The only condition to getting that is that you can't withdraw any of the money from that LISA until you're either buying your first house or until you retire at 60. Regardless of which of those two options you go for, the LISA is well worth getting in addition to an ISA because over time, if you can keep making use of that four thousand pounds annual allowance, getting that one thousand pound bonus, you can get up to 32,000 pounds of free cash from the government in addition to an unlimited amount of tax savings from the interest in Capital Growth that you return. My recommendation for an ISA is with Trading 212, which is a firm that allows you to buy shares and invest in funds with no commission. And my recommendation for a LISA account is with Hargreaves Lansdowne.
Conclusion
Every single person in the UK probably agrees that they pay too much tax, and whilst tax rates have been steadily increasing for a number of years, fortunately, there are still a number of ways to reduce the amount of tax that we all pay. So, do your own research into the methods that I've just run through today, see how many of those apply to you, and use them to reduce your tax bill as much as possible.
📝 Highlights
- Understanding the UK tax system is crucial to reducing your tax bill.
- Tax reliefs and allowances can help you protect your income and reduce the amount of tax you pay.
- Pensions, running your own company, and investing in an ISA are all effective ways to reduce your tax bill.
- The lifetime ISA (LISA) is a great way to get free money from the government.
- Do your own research to find out which tax reliefs and allowances apply to you.
📝 FAQ
Q: What is a pension?
A: A pension is a savings account that you deposit into, with the only difference being that you can't touch those savings until you retire from work, which is likely to be in your 60s.
Q: How can I reduce my tax bill if I own my own business?
A: One of the easiest ways to reduce how much tax you legally pay is to run that business or side hustle through a company. As a company, you're able to deduct business-related expenses from your income, and that reduces the tax that you owe to the tax man.
Q: What is an ISA?
A: An ISA is essentially an investment account that you can save up to twenty thousand pounds a year into, and that amount is shielded from any tax charges whatsoever.
Q: What is a lifetime ISA (LISA)?
A: The lifetime ISA (LISA) is a special type of savings account that has a 4,000 pounds annual limit and comes with a 25 percent cashback bonus for free.
