As most of you know I am an Independent Financial Adviser and see lots of people’s finances every day.
One thing I have come to realise is that the financial system is way too complicated for most people to understand so the purpose of this blog is to try and drip feed little bits of information that might give you that ‘Hmm I never thought of that’ moment!
One thing that I notice is that proportionately the higher earners do not pay as much tax as you think. They certainly do not if they have an adviser that is for sure.
I know what you think... Higher rate tax payers pay 40% tax and Basic rate tax payers pay 20% right? Wrong!!
Let me show you how your boss earning £70,000 could be paying a 22% tax rate whilst you earning a very respectable £40,000 are paying a 23% tax rate:
Simply put excluding deductions for pensions and student loan your £40,000 has the following happen to it.
Between £0 and £12,500 you pay no income tax – wahoo!
Between £12,500 and £40,000 you pay 20% income tax which equates to £5,500 of income tax.
But then National Insurance sneaks in and rears it’s head and scuppers everything by adding another tax that you and most others probably do not think about.
As an employee you pay National Insurance contributions if you earn more than £183 a week. Once you earn this much you pay 12% of your earnings over and above this amount up until £962 a week for the tax year 2020-21. Then weirdly the rate drops to 2% of your earnings over £962 a week.
So back to you earning your £40,000 a year. You are earning £769.23 per week (which is more than the £183 and less than the £962). You therefore pay 12% on £586.23 per week (£769.23 - £183). Over a year this means that you end up paying national insurance of £3,658.07 – Boo!
Now we just add together the £3,658 and the £5,500 and you have just paid a whopping £9,208 of what is essentially tax which is over 23% of your income.
The Boss Without A Plan Pays 29% Tax & With A Plan Pays 22% Tax
So now let’s imagine your boss earns £70,000.
Silly Boss : No Plan
We have all worked for silly bosses who leave us scratching our heads wondering why we are working for them or how they got their position.. they are usually the type with no plan in the workplace or outside of it.
They pay the same National Insurance rate as you but only on their earnings up to £50,024 per annum then the National Insurance rate above that amount drops to 2%. At the figure of £50,000 their tax rate increases from 20% to 40%. Put all that together and their £70,000 has deductions of £20,759 or what is essentially tax of over 29%.
Got all that? Good!
Clever The Boss With A Plan Now imagine they have met with a financial adviser who has told them to put £1,000 per month away into their pension. Pensions get really good tax incentives which give huge savings to tax bills and importantly help save for your future.
With that £1,000 per month contribution to their pension your boss is now paying total tax and national insurance on remuneration of £58,000 rather than £70,000 and they are getting £12,000 set aside into their pension for their future.
This means their tax and national insurance is now down to £15,720 or just over 22% of their total remuneration.
In this scenario your boss is paying less tax proportionately than you are. That is crazy isn’t it, but let’s not get angry with them, let’s work out how you change the things you can control.
How Can I Pay Less Tax?
One really good practice to get into though is to invest your pay rise. You have got used to living on your current salary and it can seem daunting to reduce the amount you have now in order to better your future but next time your salary goes up don’t increase the amount you spend, instead increase the amount you save. Obviously there is some wiggle room here but it is a really good habit to get in to. Your pay goes up by £200 per month then invest half of the pay rise and spend the rest.
For instance, Investing £100 per month into a tax efficient vehicle like an ISA over 25 years with an average compound growth rate of 5.75% net would be worth £65,528. If instead you invested the full £200 per month it would be worth £131,057. This shows that a small change doesn't produce Small Change!
This is all great but what can I do to improve my finances?
Simply call a local independent financial adviser - most will happily have an informal chat with you and help guide you to useful resources and, importantly from your perspective, identify if there is a need for advice. You should not pay an independent financial adviser for a chat or a first meeting and the great news is that we have to be qualified to offer advice and most advisers are very good at their jobs!
If you don't know much about the advice process then we have created a 6-step guide here.
The contents of this article do not constitute financial advice. You should always speak to a regulated independent financial adviser prior to enacting anything discussed in this blog. Investments can go down as well as up and your capital is at risk.