My favourite three letter wording ending with x

**I started writing this a while ago – the tax bands will be out of date quite quick.  The principles still apply though**

Whilst doing some weights a while ago I strained my back.  This left me hobbling about and generally not able to do much, not even ride my trusty steed to the shop for groceries.

With so much pent up energy I needed something to do.  I eventually turned my energies to everyone’s favourite three letter word ending with ‘x’.  Tax.

The tax system in the UK in painfully convoluted.  Years ago when I was studying to qualify as accountant I struggled with the tax modules, not always from an academic perspective but from a ‘why’ perspective.

Coming from an engineering degree, I learned about things called ‘laws’.  The laws of thermodynamics, aerodynamics, materials, mana, electricity and gravity.  These weren’t just invented by someone, they were discovered by a scientist/engineer through rigorous testing and evaluation.  The Scientific Method.  The laws were what they were, and that was that.

When you teeter over the event-horizon into the world of man made rules and regulation like taxation, then it’s a different ball game all together.  Thankfully there is no politician with a half-arsed and self centred idea changing Newton’s Three Laws of Motion.  No local councillor hell bent on self preservation changing the 2nd law of Thermodynamics.

There was a lovely logic to engineering, understand the principles behind something and you did actually understand it.  I’m buggered if I know what the difference between income tax and National insurance actually is.

With tax, oohhh no sir. things can just change.  Annoying for anyone studying the subject as it can be out of date next month and equally annoying for anyone trying to plan their financial future.  The lack of stability of regulation really is a bitch.

So how does the personal tax environment look at the moment?  A superb dinner party line, take it, use it, it’s yours.  Just be careful with it.

After a brief bit of Excel spreadsheeting I came up with this;

Marginal and effective tax rates

Zombie-Tax-O-Matic

This is for a single person with no pension savings, so just paying tax at the normal rates.

The orange line is your marginal tax rate, the rate of tax you pay on the next £ you make.  My graph includes both NI and income tax.

The blue line is the total cumulative tax rate paid across all your income, staying below 40% in all cases above.

The grey line is total tax paid annually, a nice steep ‘reach-for-the-lasers’ kind of gradient.

The Marginal Rate is perhaps the most interesting.  It doesn’t last long at 0% before it steps up to 32% (12% NI and 20% income tax) and then again up to 42% as you earn over £42,385 (2% NI and 40% income tax).

There is a bizarre spike as you reach £100k in income, with the Marginal Rate peaking at 62%.  Here you get 38p to take home out of every £1 you earn.  The spike is because your personal allowance is slowly taken away once you start earning £100k.

Earning more is always nice.  You wouldn’t turn down a payrise from £40k to £110k for doing the same job just due to tax.  You won’t actually get taxed more than you earn.  But paying more tax above some arbitrary number isn’t very nice.  Was the hour you worked just after earning £42,385 really worthy of 10% more tax than the hour just before it? Was your last hour as someone earning £110k really worth attracting 62% tax and the hour after it only 42% tax?

As much as we complain about taxes, we don’t have it the worst (or the best) if this is anything to go by.

It’s not hard to see why the defined contribution pension has proved so popular, especially for those in the upper tax bands.  A pension scheme effectively defers your tax liability, so instead of paying tax on your earning now you pay it when you drawdown from your pension.  You avoid your marginal tax rate by contributing to a scheme.

It becomes beneficial if you are a higher rate payer upfront, and a lower rate tax payer in retirement.  For example, if you are higher rate tax payer now and on drawing down from your pension a lower rate tax payer you will effectively save the difference in tax.  And that saving is even bigger if you are a higher rate tax payer now and looking like being under your personal allowance when drawing from a pension. Lovely.

Let’s say you earn £48k.  You would be suffering a 42% Marginal Tax Rate on your earnings above £42,385.  If you then put the £5,615 of earning above £42,285 into a personal pension scheme (with salary sacrifice to make it easier) you wouldn’t pay any tax on it, your marginal tax rate would have dropped to 0% on these contributions.  Roll forward a few years and you sneakily only drawdown your personal allowance each year, then you would pay no income tax.  So a tax saving of 42%, the arrow on the right below.   If you were earning the equivalent of £30k then your tax saving would be smaller at 20%, the arrow on the left below.

Marginal Tax impacts - Pension

Some potential deferred tax saving offered by personal pensions

 

Pension regulation seems to be in a constant state of flux, an ever changing environment.  The benefits in the form of tax sheltering that a pension scheme offer look likely to be reduced in the near future, despite escaping the latest Budget.  Perhaps we will look back upon these fortuitous times wondering why we weren’t putting 100% of our salaries into pension schemes.  Or we will look back and laugh heartily at the puny tax advantages on offer.  Who knows.

Tax planning isn’t isolated to the accumulation phase.  Oh no, that pleasure is equally important once you are financially independent, and living off your precious savings.  After saving hard and building up a nest egg you don’t want it to be shattered by a tax-jack-hammer.  Breaching the personal allowance limit means a spike in the marginal tax rate from 0% up to 20% (if we ignore National Insurance now).  That’s quite a jump.

Any of us that have been thinking about Financial Independence for any amount of time quickly ask the question “Just how much will I need?”.  A quick google search will point you the way of the 4% rule, suggesting that a fund will support 4% of it’s value after taking inflation into account, pretty much forever.

What impact does tax have on the 4% rule?  If you are talking less than your personal allowance (£10,600 currently, £11,000 in 2016/17) then tax has no impact, as you won’t get taxed on your income.

Start exceeding the personal allowance and income tax jumps on the scene and, like a professional wood worker, it starts to whittle away at your 4%, effectively reducing it.

The 4% rule tends to be presented as take you annual expenses and multiply them by 25 and that is how much you need to save.  But that has no consideration for tax, and that is a big omission in my crusty dead peepers.

Now, it depends on how you are taking your income.  Income taken from a pension is different to dividend income, which is different to taking money out as ISA which is different again to selling down shares in a taxable account and incurring Capital Gains Tax.

Consider drawing from a pension, as that comes under the income tax bracket which we are more familiar with.

Let’s consider a new term, the “Marginal Withdrawal Rate”.  With withdrawal income under your personal allowance it would still be at 4%.

But once you are in excess of your personal allowance the withdrawal rate is hacked down, because you are paying 20% income tax.  Every £1 you withdraw now only provides 80p of income, with 20p of tax being paid.  Your Marginal Withdrawal Rate has dropped to 3.2%, remember a lower withdrawal rate is worse.  It means you need more capital for the same income, or the same capital will provide a smaller income.

The graph below shows the Marginal Withdrawal Rate and the total effective Withdrawal Rate as you draw income from a pension and start to incur tax.

Marginal withdrawal rates

Marginal withdrawal rates – remember smaller is BAD

Let’s say you were looking to survive on £22k of income a year, completely provided by your pension.

The 4% rule suggests that this would need total investments of £550k.

But, wait a second there, ol’ wise Mr Zombie has spotted a problem.  Due to tax you are now paying you have an effective withdrawal rate of 3.59% and you would need investments of £614k.

A difference of £64k is nothing to be sneezed at, especially for what looks like only a small decrease in the withdrawal rate of 0.41%.  

Or looking at it another way, a 4% withdrawal rate means you need £25 of capital, for £1 of income.  At a marginal withdrawal rate of 3.2% every additional £1 of income now requires £31.25 of capital to support it.  Like a little fella and a step ladder, that’s a big step up.

This isn’t meant to shock you so bad you throw your phone against the cubicle wall and let out a guttural roar, terrifying your colleagues in other cubicles whilst shouting a cryptic “who knew 0.41% would be so costly!”.

The message is clear, small impacts to your withdrawal rate can have big impacts on how much you need to save for your Financial Independence.

Tax planning is important and sexy in both the accumulation phase and the drawdown phase.  RIT did an excellent article a little while back, showing that it is possible to generate nearly £23k of income without paying any tax, as long as your investments were structured right.

If there’s one certainty, it’s that the tax rules won’t stay still for very long.  So just like in our careers and life in general, we need to remain flexible.  Flexible in how we drawdown our income.  And keep our investments diversified so our plans aren’t unhinged by one madman and his changes to tax rules.

There are three obvious tools available to us to help our tax planning while investing;

1 – control your spending.  Spending kept under the personal allowance doesn’t attract any tax and leaves your withdrawal rate assumption unmolested.

2 – use your ISA allowance.  Your ISA shelters investments from tax and ultimately means that your Marginal Withdrawal Rate remains unchanged.

3 – use your personal pension, carefully.  Effectively deferring when income is considered for taxation you could reduce your marginal rate.

The ISA vs pension (vs Lifetime ISA?) debate will rage on, I’d take the diversified approach and use both.

Remember that some careful tax planning reduces the amount of tax you pay in accumulation and the amount that you need to accumulate for Financial Independence, due to tax paid.

Let’s look at an example to really drive the tax efficiency stake into your black savers heart.  Consider two people both earning a nice round £60,000, Mrs Sensible and Mr Reckless.  Despite their names, they both have the same annual expenditure of £20,000.

Mr Reckless takes home £42,126 after tax, and so after spending £20,000 saves a respectable £22,126 a year.  This is all saved in a taxable account, let’s assume 100% equity.

Mrs Sensible uses her employers pension scheme, which matches up to 6%, and her full ISA allowance each year.  The rest of savings are put into a taxable account.  This leaves Mrs Sensible with £7,200 going into a pension (including the employers match), £15,240 going into an ISA each year and the remaining £5,205 going into taxable accounts for a total of £27,645 saved each year.

That’s already an extra £5,518 saved per year by using the employers pension, benefiting from both the employer match and the tax deferral.

Let’s leave them to run over the next 20 years with level contributions and a growth rate of 5%.

Way to go Mrs Sensible

Way to go Mrs Sensible

Not surprising really, Mrs Sensible has more after 20 years as she has contributed more, £182k more if we want to split hairs.

Let’s now assume that they are both looking to become Financially Independent using investments of £500k, to support an annual expenditure of £20k at 4%.  Let’s ignore tax on the way out for now, we are all tired.  That will be the next part in the series.

Looking at the graph above reaching £500k happens somewhere between saving for 15 and 16 years, for Mr Reckless.

It happens 2 years earlier for Mrs Sensible.

Just by using the company pension and ISA she has reduced her time to FI by a couple of years.

 

Structuring the way you drawdown is just as important as structuring your accumulation, but we will leave that for another post.  There are many variables in this;

  • Dividends
  • Capital Gains Tax
  • Income Tax
  • etc

Which would lead to another 2,000 words.  No one needs that now.

For now, thinking about tax can help boost our investments in the accumulation phase as well as extending their life during the drawdown phase.  And that is time worth spent indeed.

Happy Easter weekend!

Mr Z

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4 thoughts on “My favourite three letter wording ending with x

  1. ermine

    Isn’t this why real zombies use both pension and ISA – save into your pension anything over the HRT tax threshold and then some of what you have left in a ISA? Was pretty much the line I took, though I had sal sac available so I went bigger on the pension as 32% win was still worth doing even if I ate 20% tax on drawdown.

    I will use exactly that policy next year – I will take the 25% lump sum, add that to my ISA over a couple of years (the 25% TFLS into an ISA makes your pension withdrawal rate about 25% less bad) so that is still untaxed, and draw to the personal allowance from the pension.

    I figure the pension and ISA will give me a tax-free income of about 16k which is more than I have been living off for the last three and a bit years. I guess I need to find something to spend it on…

    Reply
    1. Mr Zombie Post author

      Ermine – sorry for my tardy response, it’s been a lazy bank holiday.

      Yeah – that’s pretty much my approach too 🙂 Take the employers contribution to the max on offer, then top up any extra HRT.

      Recycling into an ISA isn’t something I have looked at in detail, but it seems an obvious option.

      Drawing down from a pension up to the PA would be my preference too. And like yourself my actual spend (ignoring my mortgage) is quite low. It’s been boosted by the wedding spending this year, but the numbers suggest £16k would be more than plenty.

      Reply
  2. theFIREstarter

    Excellent article on Tax Mr Z!

    Yes my approach has been to chuck anything over the higher rate into a SIPP (already done a fair bit over the last two years, but not likely to bother for this tax year we’re in or going forward much more because I am now part time to under the bracket again!) and fill up ISA’s as much as possible for the rest of it. Obviously I also have a work pension which is ticking along nicely. I guess the issue for very early retirees is trying not to blow all of your ISA capital before you get to the age you can access the SIPP/pension isn’t it!

    As mentioned in the brackets above, now I’m part time I think I’m going to be more than happy working for longer so probably won’t reach “full FI” till I’m about 50 anyway, and that’s with no unforseen huge expenses or changes in work, not likely…! But let’s just say it does pan out like that, I only have to bridge the gap between 50 and what, 57 it’s likely to be by then, to access the TFLS of the pension. Hopefully I’ll have enough in the ISA’s over 15 more years of savings to last me a mere 7 years (and then some)!

    Then withdraw the TFLS, and use that until can properly start withdrawing from the pensions, and back it up with anything left over in the ISAs.

    The plan can and will change as the laws change though. The lifetime ISA for example is another potential avenue to put some savings towards.

    Under the money tree also did a great post on tax free income, think he worked out it was around £33K for a couple which would easily cover our currently lifestyle assuming we were mortgage free. In fact we’d be living like Kings on that compared to what we are spending right now! PARTY TIME! 🙂

    Reply
  3. VeryMeanReversion

    (1) If your company lets you have their NI savings via a salary sacrifice scheme, you can save another 12% on your marginal rate. i.e. avoid on the way in, don’t pay on the way out.

    (2) If you have a couple of kids and are receiving child benefit, your marginal rate increases by ~17% in the £50-60K income range. (higher % for more kids, lower % for less)

    So in my case, I found I had to put everything above £50K into pension to avoid a 65-70% effective marginal tax rate.

    Reply

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