Five Top Ways To Avoid Tax

Don't pay more tax than you should with these five top tips.

'In this world nothing is certain but death and taxes'.

How true. For most of us paying tax is an inescapable fact of life. But what's worse than having to pay tax? Paying more than you need to. While tax implications should never be the only factor you take into consideration when making investment decisions, here are five tops tips which could help you reduce your tax bill.

1. Open A Cash Individual Savings Account (ISA) - This tax year, which runs until 5^th April 2008, you can save up to £3,000 in a Cash ISA and receive interest absolutely tax-free. If you save for a full year into a cash ISA which pays interest of say, 6% you'll earn £180 without having to pay a penny in tax. And if you use your allowance every tax year these savings can really add up.

Outside an ISA, if you're a basic rate taxpayer and you decide to stash your £3,000 in an ordinary, taxable savings account you will only get back £144 after twelve months. Worse still, if you're a higher rate tax payer you'll earn just £108.

The Chancellor has enhanced these tax-free incentives by pledging to increase the investment limit to £3,600 from the beginning of the new tax year on 6^th April 2008.

If you want to invest your money in something a little more adventurous, you could go for a stock and shares ISA. You can invest up to £7,000 in total, although if you do you won't be able to invest in a cash ISA as well. Alternatively, you could hold £3,000 in cash and use the remaining £4,000 to invest on the stock market. The overall contribution limit will be stepped up to £7,200 next April.

Stocks and shares ISAs aren't entirely tax-free as there is a deduction on dividends, but any capital gains you make will be sheltered from tax.  

2. Use National Savings & Investments (NS&I) - NS&I offer a range of tax-free products which could be right up your street. What's more, NS&I is backed by HM Treasury, which means your money is 100% secure. A safe haven for your cash may be particularly important to you now given the current banking environment.

You can invest a whopping £93,000 tax-free with NS&I in a range of savings certificates, cash ISAs and premium bonds. Here I've summarised the options available to you and the current rates of return:

(1) - Annual rate used to calculate prize fund for monthly draws.

3. Make Pension Contributions - Pensions are a really tax-efficient way to save as you'll receive tax relief on your contributions. There's no restriction on the amount you can pay into a pension although you'll only qualify for tax relief on the higher of 100% of your UK taxable earnings (up to a maximum of £225,000 for the current tax year) or £3,600. This means if you're a non-earner you can still benefit from tax relief on contributions up to £3,600 (gross) with a net payment from you of £2,808.

If you're a basic rate taxpayer you'll receive tax relief at a rate of 22%. This means for every £78 you invest in your pension, you'll attract tax relief making the `grossed-up' contribution £100. Even better, if you're a higher rate taxpayer you'll  receive tax relief at 40% which means a net investment of just £60 will be `grossed-up' to £100.  

If you're a basic rate taxpayer but you expect to start paying tax at the higher rate in the future you can combine ISAs and pensions into your retirement planning strategy. The idea is that you save into a stocks and shares ISA to begin with and then later move your accumulated fund into a pension scheme when you fall into the higher rate tax bracket. This will entitle you to 40% tax relief on your entire pension contribution (assuming the amount doesn't exceed 100% of your taxable earnings). 

4. Use Your Personal Allowance - This tax year we're all entitled to earn the first £5,225 of our income tax-free. If you're over 65 or 75, your personal allowances will be stepped up as shown below.

Income Tax Allowances Tables

(1) - These allowances reduce where the income is above the income limit (£20,900 in the current tax year) by £1 for every £2 of income above the limit. They will never be less than the basic Personal allowance or minimum amount of Married Couple's allowance.

What do I mean by using your personal allowance? Well, for example, assume you're married and your spouse is a non-earner (or a lower earner) while you're a higher rate taxpayer, it makes sense to move income producing assets, such as shares or savings accounts, into the non-earning spouse's name to maximise their personal allowance and ultimately pay less tax.

5. Maximise Your Capital Gains Tax (CGT) Exemption - Each tax year a proportion of any capital gain you realise from your assets are free of tax. The annual exemption for this the 2007-08 tax year is £9,200 although it'll be up-rated in each subsequent tax year. Gains made above this limit are added onto the top of your income and are chargeable to CGT at the following rates:  

• Below the starting rate limit at 10%,
• Between the starting rate and basic rate limits at 20%,
• Above the basic rate limit at 40%.

In an ideal world you would ensure your capital gains don't exceed the exemption in any one tax year, which would enable you to take larger gains over a number of successive tax years and avoid CGT altogether.

So there you have it. Five top tax saving tips everyone should know about.

More: Tax Havens For Investors | If you already have premium bonds find out if you've won here!