Do you (like me) not think of Income Tax as an outgoing / expense – it’s just something you complain about but don’t think of it as an expense of yours?
Tax is an expense and something that you can’t ignore – even if you think you’ll be able to avoid. Policies can change and early retirees tax burden can change too.
This post is not about why tax is bad or how to avoid/evade it (the difference between the two being a good accountant). But it’s just about how it’s maybe a missing item from how we view our financial affairs.
It’s my view that tax deserves to be paid and what we get for our taxes should be good quality. However, the tax system in the UK is not simple and on a personal level it makes sense to reduce your tax burden.
There are of course other taxes like council tax, VAT, excise duties on alcohol and tobacco, stamp duty on hours and shares, vehicle excise duty, capital gains tax, air passenger duty and (if you are lucky) inheritance tax.
But I’d like to focus on income tax and national insurance as these are the biggest taxes for most people who are pursuing FI in the UK.
I have a record of my salaries paid to be for almost 15 years now. I’ve kept an eye on everything over the years and have the graphs to prove it! But I’ve never paid much attention to the Income Tax (and National Insurance) paid. On one level that’s because it’s rather inevitable – as a PAYE employee you have not much chance to escape it but also because it’s a bit depressing. If your boss gives you a pay rise of £1,000 when your salary is £50,000 a year, then £400 gets taken in Income Tax and £20 in NI. That £1,000 has actually cost your employer an extra £133 in Employers NI meaning you only get paid an extra 51% of the cost.
If part of your plan to achieve FI is to work hard, earn well, invest wisely – then the government doesn’t make it very attractive. You could argue that the pensions set-up in the UK (where you get tax relief at your marginal tax rate – 20%/40%/45% – and take it when your retire around 60 at your marginal tax rate – 0%/20%?) benefits higher earners – which is debatable* but the odds are stacked against those who want to reach FI and Retire Early.
If you plan to survive for 20 years on the natural yield of your investments then spending £30,000 net could mean you need between an extra £1,000 to £3,000 of tax to pay. Sure, it’s a lot less than if you earn that through working but tax on your investments means 100% of your returns are not yours to keep. Have you factored that into your own calculations? Also, it’s possible that tax rates could change in the future – in fact it’s inevitable that some changes will be made in some form or another. In the past, dividends were not taxed if you were a 20% tax payer – that increase to 7.5% in 2016 and cost people up to around £2,000! Then there was a £5,000 dividends allowance which was scaled back to £2,000. It’s all very confusing!
The UK tax system has very generous allowances for interest on savings, dividends, nil-rate for NI and income tax threshold, schemes like ISAs and LISAs plus the tax allowance for the rich – capital gains tax. But that doesn’t mean that you’ll never pay income tax again and if you approach FI, then you may find that you have more money then you know what to do with (a lucky situation you might think). The taxes on capital (CGT, dividend tax, savings tax) are also less than the combined cost of NIs and Income Tax on paid labour.
If you have a partner in life, not only can your cost of living be lower (per person) but you can also avail of tax arbitrage and twice the different allowances for Income tax, ISAs, Pensions and so on.
There is no one way to do it and everyone’s affairs are different. It’ll take you some time to work out what the best way forward is and even then there are lots of variables that may affect your plans for the next couple of decades. It might even be worthwhile paying for professional advice from a chartered financial planner, they have a better understanding of the tax system than amateurs do (how reliable is tax advice from the internet anyway?). I’ve never used one myself but with my new company, there is a fine line between accountancy services and investment guidance.
Also, if you are a higher earner and established in your career it might be worthwhile considering going contract. The main advantage professionally is that you can work on what you want, when you want and (maybe) how you want. Incorporation has other benefits but it does muddy the waters.
In conclusion, tax and planning for tax will be a part of all of our lives for the future. We can look at a range of ways to reduce its impact on us – from vanilla (ISAs, workplace pensions) to the more exotic (VCTs, salary sacrifice). It is not enough to just think that “I can live a tax-free FI life” because the rules might change in the future to tax capital more than labour, or pension tax relief or lifetime allowance rules change. Estimating an effective tax rate of 15% might be an effective way of putting a more realistic number on your post-FI spending – so if yo think that you can get by on £25,000 a year (roughly what we think) we’d need £29,411 – and you can take that £4,411 as a contingency or to allow for tax but it gives a more conservative figure.
For us, it’s a matter of balancing the income/assets/tax liabilities for myself and the Lady – that way we can take most advantage to minimise our tax exposure.
Good luck, GFF
*The very fact that it is debated (like here) means that changes might be afoot. Other ways of raising tax like a sensible Land Value Tax or even capital gains tax on your primary residence, updating Council Tax banding are less likely to ever happen.