Rachel Vahey: Working through the tax allowance maze

Not content with tackling inheritance tax, the Office of Tax Simplification has turned its attention to the taxation of savings income. Rachel Vahey offers her thoughts on where they should particularly focus

The Office of Tax Simplification (OTS) is a busy place these days. It is currently having a good hard look at inheritance tax and asking how to simplify the convoluted tangle of rules and allowances. Still, not content with taking on that behemoth, it has also turned its attention to the taxation of savings income.

In late May, it published a paper performing a comprehensive sweep of the various ways savings income is taxed and focusing on the complexities the ordinary person encounters every day. There is little doubt ironing out some of these intricacies would be a positive step forward.

Understanding what income you will receive is central to the decision about what is the right investment for you. If more people understand how they will be taxed – or, better still, if the system was significantly simpler – they may be more confident in their savings decisions, hopefully leading to them saving more for later life.

The good news is that 95% of people pay no tax on their savings income (held in cash and stocks and shares). The introduction of the personal savings allowance (PSA) from April 2016 has helped in this regard – though it has also added to the maze of allowances, all with different rates and starting points. And this maze can be so difficult to navigate that even HMRC’s self-assessment computer software has sometimes failed to get it right.

The OTS is pleading for a little clarity. This could be achieved by, for example, specifying the order allowances are to be deducted, making the PSA and the tax-free dividend allowance true allowances rather than a nil rate of taxation, and amalgamating the starting rate with the PSA to create a combined allowance.

The OTS is also toying with more extreme proposals, such as exempting savings interest completely for basic rate taxpayers, or individuals with income below a certain threshold, or those above pension age. This more-radical approach would mean the Treasury accepting a cut in taxation revenue, and could potentially create a cliff edge for income threshold or age – but maybe radical thoughts are called for …

The OTS also rightly picks up on the ever-expanding range of Isa choices, and questions how the lifetime Isa fits in. The lifetime Isa has hardly been a runaway success. The Office of Budget Responsibility described it as having a ‘sluggish’ start and has slashed its estimate of how much money will be paid in by a whopping 40%.

We agree with the OTS that lifetime Isa penalty charges urgently need reviewing. If the saver decides to access their money ‘early’, then only the government bonus should be deducted – they should not be punished with a further 6.25% charge.

Many people would benefit from more guidance and advice when deciding whether or not the lifetime Isa is right for them. It only seems fair to change the rules to allow adviser charges to be taken from a lifetime Isa without incurring a withdrawal penalty.

Isas are the one savings vehicle people seem to ‘get’ and, importantly, trust – but that does not mean they are perfect. In particular, there is confusion around transfers and, especially, partial transfers. It would be good to get rid of the ‘one-Isa-type-per-tax-year’ rule, which is so unwieldy in practice. We want people to have the flexibility to save up to their Isa subscription level without having to dance around these cumbersome rules.

Cause of consternation

Finally, the taxation of lump sums from flexi-access drawdown remains a cause of consternation. These are taxed on an ‘emergency tax code basis’ if the pension scheme does not have a tax code for the individual – which normally they do not for the first payment.

Even where the scheme has a tax code, the payment is taxed in the month paid, whereas historically lump sums were taxed as if they were paid at the end of the tax year, guaranteeing the correct personal allowances would be used.

Although any overpayment can be recovered by submitting forms to HMRC, we witness many unintended consequences from this approach. Some people do not know – or perhaps cannot be bothered – to fill in the forms, and their inertia means their tax situation remains uncorrected for several months. Others, to realise enough money to meet their immediate demands, take out more than necessary. This fuels concerns over the sustainability of drawdown funds, and whether people will have enough to last their lifetime.

So far, £37m of tax has been repaid by HMRC following the overpayment of tax on lump sums, resulting in unwanted administration and confusion for all involved, including HMRC. We live in hope HMRC will look again at this, as well as the wider savings maze, and adopt a simpler approach.

Rachel Vahey is product technical manager at Nucleus Financial