The Office of Tax Simplification has launched the first broad review of its type into the application of the tax system to savings and investment income, covering amongst other things, savings and dividend income, Individual Savings Accounts (ISA’s), and pension income.
In its report Savings income: routes to simplification, the OTS found that many taxpayers continue to worry about the tax treatment of their savings income unnecessarily, as 95% of people pay no tax on savings income. There are also many specific complexities which people find difficult and confusing.
Although approximately 65% of UK adults save some of their income and many have a private pension (78% of employees, 17% of self-employed), it is estimated that around half of the country’s population is not saving enough for their retirement. Furthermore, at the average rate of savings, it would take 18 years to save a deposit on a first home, or 17 years in a cash ISA.
Studies show that financial literacy in the UK is relatively low compared to the OECD average. UK individuals who self-assess their knowledge in this area as high do not fare any better than average when measured against people from high-performing countries on objective tests. In light of this revelation there is scope to significantly improve guidance and education on the taxation of savings to help individuals make more informed choices, and the OTS have strongly urged HMRC to focus improving its guidance and making it easier to understand.
The starting rate for savings, personal savings allowance, dividend allowance and other allowances and features of the tax system mean that most people do not pay tax on their savings. However, the interactions between the rates and allowances is sufficiently complex that even HMRC’s Self-Assessment computer software has sometimes failed to get it right! In the last tax year it produced incorrect results in a number of scenarios.
Income other than savings or dividends income (non-savings income) is taxed first, savings income is next, and dividends are treated as the highest slice of total income.
The starting rate for savings can apply where taxable non-savings income, i.e. earnings, pensions or rental income, is less than the starting rate limit of £5,000. Savings income up to the difference between the taxable non-savings income and £5,000 will be charged at the 0% starting rate for savings. So, if a person has taxable non-savings income of £3,000 and savings income of £2,500, £2,000 of the savings income will be taxed at the nil rate. Where the non-savings component exceeds £5,000, then the starting rate for savings cannot apply.
Additionally, the personal savings allowance (PSA) provides a further savings nil rate:
|Income Taxed at||Allowance|
|Higher rate but not additional rate||£500|
Calculations of tax across the different rate bands and allowances, together with the dividend allowance and rates, are far from straightforward.
Whilst the different elements of income are assessed to tax in a defined order of priority, the allocation of personal allowances should be made in the way which will result in the greatest reduction in the liability to tax, which is what HMRC has failed to do in a number of cases in the last tax year.
Further complications arise for Scottish and Welsh taxpayers because dividends and savings rates are not devolved, unlike the main rates.
Banks may pay different types of income to its customers but they are not all taxed in a uniformed way as demonstrated by the table below:
|Income Type||How paid by bank||Within PSA||Reportable by banks to HMRC|
|ISA interest||Tax free||No||Yes|
A single payment by a bank could therefore have two different tax treatments, for example a refund of overpaid interest plus compensation interest.
The introduction of the dividend allowance in 2016 was to reduce tax-motivated incorporation by increasing the income tax charge on distributions of profit to a similar level to the taxation of profits extracted from unincorporated businesses. The dividend allowance was then created to avoid individual investors having to account for relatively small amounts of tax on their dividend income.
Rather than being an exemption from tax, it is another nil rate.
With few taxpayers able to check their own tax calculations of savings and dividend income unaided and the position on where to save less clear for the investor, the OTS have suggested a number of potential approaches to help simplify this whole area:
A personal tax roadmap should also be put in place setting out the key changes planned and a timetable for reform.
ISAs were introduced in 1999 and replaced Personal Equity Plans (PEPs) and Tax Exempt Special Savings Accounts (TESSAs). They are free of income tax and capital gains tax, thereby providing a tax- free wrapper for investments. Since then, further ISAs have been introduced:
Although the general principles of how ISAs work are well understood, some of the finer detail is confusing and the OTS therefore considers that further changes should be made to simplify ISA rules. For example, allowing partial transfers of money invested in year or removing the requirement that an investor may only take out one ISA of each type per year, subject to the overall annual limit.
Particular difficulties are posed by the treatment of lump sum withdrawals from personal pensions. In addition, people who deferred taking the state pension before April 2016 have an option to receive a lump sum payment of deferred income but gov.uk does not explain the special tax treatment of these payments which causes great confusion.
More could be done to help people understand the tax implications of withdrawals from pension funds and the actions they may need to take.
When an individual draws a personal pension lump sum, many suffer an emergency tax deduction which generally results in too much tax being withheld. Other options should therefore be identified.
The report also covers life insurance bond withdrawals and Collective Investment Schemes.