Tax: the elephant in FI the room

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.

12 comments

  1. I don’t mind paying tax out of my pay as it’s my contribution to the society I choose to live in – the only time it bothered me was when I was in debt because every penny counted then.

    My intention however when I pull the plug on working, is to not pay any tax (or as little as possible) for as long as possible. This means my income post-work will be largely funded by my ISA. I’ll keep my SIPP withrdawals low so I don’t hit the personal allowance limit. This all depends on me having a large enough stash in my ISA, which I continue to work on but which ultimately depends on market forces.

    I know it sounds bad that at this point, I won’t be making a contribution but I will have paid 35 years of tax and NI by this point, which I think is more than enough!

    Liked by 1 person

  2. I don’t view tax as theft (though I am keen to avoid it), with one exception: taxation that is effectively retro-active.

    But even legitimate taxes can have noxious effects. A member of my extended family, who likes to consult Uncle Dearieme on financial matters, returned from running his own service company to the world of the salaried employee a few years ago. He was so appalled at the tax he had to pay that he threw it in and went off to work in a lower tax economy abroad.

    (Not only did the tax rates annoy him but also the complexity. A 60% income tax band! A tapered annual allowance for pension contributions! Child credits (or was it benefits?) buggered about!)

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    • tax is what you pay and services are what you get. I don’t really mind either paying taxes – but we will all try to have our cake and avoid paying for it too.

      Regarding moving away to a lower tax economy/country – those things might change and if low cost = low tax – don’t expect it to stay the same forever.

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  3. I am currently using Salary Sacrifice to pay as much as possible into my pension. My employer allows me to sacrifice down to the taxable earnings threshold and they also pay half the employer NI savings into my pension. This has almost taken me out of income tax as I have a few years pension carryover to use up. I’m still exposed to other taxes and I also have to pay tax on my BTL profits. Additionally if I breach the pension LTA in future I’ll get taxed further so I have no shame in using Salary Sacrifice.I’m alos continuing to save into my ISA as I’m well aware that my future pension income will be subject to tax.

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    • salary sacrifice is a funny one – the government facilitates it but also condemns its use.
      Once I worked out about the benefits of salary sacrifice I paid in as much as I could (to the point of earning the min. wage) – this despite our family spending (plus childcare costs) being larger than our combined take-home pay. Luckily we had the money/assets to withstand that but so many people don’t and they have to make a painful decision of Jam(my or Nanny) today.
      I think that ISAs are bullet proof in terms of tax – but I regret not paying more into ours over the years.

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      • I’m doing a similar thing. Previously I’ve paid down all debt and built up a significant savings pot. With interest rates so low it makes sense to Salary Sacrifice as much as possible and meet any day to day earnings shortfall by drawing down savings ( as long as I can still make the full annual ISA contribution ). This approach means that my family are still able to qualify for Child Benefit and the tax on my BTL profits remain at 20% rather than 40%. When I joined my latest employer I had quite a detailed discussion with the pension team before signing up. My colleagues think I’m a loon but this year I’m on target to pay a total of £7 in PAYE – that’s for the entire year. The pension LTA remains a concern so I’ll need to plan accordingly to avoid future painful pension tax.Childcare is indeed a painful expense. We were paying about £880 a month for a single child but it enabled us both to continue working. I have no qualms about using the tax optimisation rules that are available to us. Over the years I’ve paid significant amounts of tax, I’m taxed on my day to day spending, I’m taxed on my BTL ( which definitely isn’t free money ), I’ll be taxed in the future on my pension income, If I buy another home I’ll be taxed extra on that ….. the list is seemingly endless.

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    • LTA: at some point in your career you could take a government job of some sort with a DB pension. Transfer your DC pensions in and then you’ll benefit from the absurdly biased good deal that DB pensions get for LTA purposes. Then you can return to work in the economy knowing that you will have what is effectively a wonderfully good index-linked annuity to look forward to when you draw the DB pension. Win, win.

      You can manipulate the LTA consequences by considering drawing the DB pension early so that it will be actuarially reduced.

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      • if that is the case then it is a scary idea for the tax-payer.
        based on some numbers I was looking at – this sort of wheeze could be very profitable and the added bonus is that it reduces your risk of LTA problems to boot!

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  4. Thanks, I’m signed up to that. The previous voucher scheme was better but I changed jobs and then only the new scheme was available.

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