FOOL'S EYE VIEW
Keep The Taxman Off Your Cash

By Alison Hunt (TMFAlly)
October 18, 2005

Although we'd all ideally like to give a little bit less to the taxman, there is often not a lot we can do about it. After all, taxes are a necessary evil that must be paid. However, there are a few things we can do to keep our finances in check and make sure we're not paying more than we need.

Additionally, there are a few situations that can creep up on us which will affect the amount of tax we pay dramatically. Here are a couple of common situations and ways we can avoid them

1. Watch out for the creeping tax bracket

Anyone earning over £4,895 in 2005/6 will know that any interest on savings held in a bank or building society account is automatically taxed at the basic rate of 20%. However, did you realise there could have be more important consequences?

Tom earns £36,500 per year, with no other income. He is therefore in the lower rate tax bracket as his total annual income is less than £37,295 (assuming he has the standard personal allowance). However, in order to calculate his income, the taxman will also consider the interest earned on any savings he may have.

Tom has £20,000, in a high interest savings account earning 5% gross, per year. As this means he will be earning an annual gross total of £1,000 in interest, this increases his total income to £37,500, £205 over that higher tax bracket threshold. This means that Tom will have to submit a tax return in order to pay the extra tax on that extra £205. What's more, Tom will now become a higher rate taxpayer, meaning that every pound of his savings must now be taxed by an extra 20%. Blimey!

Can Tom avoid this situation?

Yes, he can. Assuming that much of Tom's savings may be required at relatively short notice (and thus should not be invested), here are some alternatives.

i) Transfer the savings into his wife's name.

Spousal transfers are tax free, so Tom could benefit by transferring at least some of his savings into his non-tax paying wife's name. This would serve to keep his income below the higher rate tax threshold and he could keep his lower rate taxpayer status. This way they could also keep the full £1,000 interest each year. Of course, Tom must trust his wife to do this, as the money will now officially be hers to do with as she wishes!

ii) Joint Savings Account

Alternatively, he could transfer the money to a joint savings account. In this way, half of the interest would be classed as Tom's and half as his wife's, meaning that his total income would fall to £37,000, just below the £37,295 limit. If his wife were a taxpayer, they would have to be careful that this method didn't increase her income to above the higher rate threshold. However, this method would mean that Tom could still have partial control over the cash.

iii) Utilise his ISA Allowance

By transferring £3,000 into a mini-cash ISA for both himself and his wife, Tom could effectively reduce his savings to £14,000, lessening the gross interest earned to £700, per year. This would keep his total income at £37,200, just £95 below the threshold, and as the interest earned by ISAs is tax free (and doesn't need to be declared on a tax return) Tom can be assured that his cash will still be safely making money, whilst not affecting his tax bracket.

iv) Premium Bonds

Tom could also consider other types of low risk investment for some of his money (minimum ca. £6,000) to bring him below the higher tax bracket threshold. Investments such as those offered by National Savings and Investments (NS&I) including Premium Bonds would provide a safe haven for his cash and, in the case of the latter, would give him the chance to win prizes worth up to £1 million, each month. And as Premium Bonds don't actually earn interest, Tom could remain a lower rate taxpayer.

Of course, assuming Tom receives regular pay rises, he will be unlikely to remain a lower rate taxpayer for too much longer. However, it will be well worth the time and effort, this year at least, to try and keep his income below the higher tax bracket threshold and keep paying basic rate tax for another year.

2. Watch out for tax on children's savings

Parents, of course, are free to give their children as much money as they wish. And as the majority of children do not pay tax, this could seem like a great way for parents to maximise the interest earned on their savings. However, be warned, the taxman doesn't look favourably upon this and has devised the £100 rule to combat parents trying to dodge tax.

The £100 Rule

Essentially, the rule states that parents can give their children a sum of money, as long as it doesn't earn more than £100, in gross interest, each year. If a child should earn just £1 over the £100 limit, the whole of the sum will be classed as part of the parent's income and taxed accordingly!

However, there are a few things you can do to maximise your child's savings whilst obeying the £100 rule.

i) Both parents have a £100 allowance

The rule is not limited to £100 interest per child, but rather £100 interest per parent. Assuming that a child's savings account had an interest rate of 5%, this would mean that each parent could give up to £2,000 in 2005/6 to remain at the £100 limit. For this reason, it would be worth making sure that half of any sum to be given was seen to come from each parent. And remember, the £100 is no longer valid once your child turns 18, or gets married.

ii) There is no maximum allowance for others

Remember, the £100 rule applies only to parents. Anyone else (friends and relatives) is free to give as much money as they wish. To avoid complication, consider opening two separate savings accounts for your child, with one earmarked for money from parents, and the other from anyone else. However, don't think you can give your mum or dad some extra money to give to your child as the taxman can track the cash!

iii) Remember form R85

It is important to note that unless you have completed a form R85 for each account your child holds, he or she will pay tax on the interest earned, anyway. Make sure you complete this form! It's also worth remembering that form R85 expires once a child turns 16. However, if your child is still in full-time education and not paying tax, they can easily rectify this themselves by completing a new form R85 for each bank account they have.

Additionally, remember that savings accounts aren't the only way to save for children. As most parents are putting money away for when their child turns 18 and heads off to University/starts work etc. it makes sense to look for the best returns possible over such a long period. And to do this, forget savings accounts, you need the stock market. And as long as the income received is minimal, this shouldn't be affected by the £100 rule.

If your child qualifies for the Child Trust Fund, up to £1,200 can be invested in his or her account, each year. Alternatively, there are a number of other cheap and easy ways to invest for a child. One important consideration should be to note the charges made by the fund manager as the more they take, the less of your profit you'll get to keep. For this reason, we at the Fool are big fans of cheap, simple index trackers.

Companies such as Legal & General offer a number of investment opportunities and with annual charges of just 0.5%, you'll be hanging onto more of the cash. And fund manager Fidelity has recently cut the charges of its MoneyBuilder UK index tracker, making it the cheapest tracker in the UK. Find out more about trackers here.

So keep an eye on your family's finances and make sure you're not paying more tax than you need, and look forward to a wealthier future!

You can find out more ways to save for kids in our Saving for Children Centre.