Fiscal drag might be something discussed in the news – but few understand what it means until they feel its impact.
Put simply, individuals are finding themselves in higher tax brackets because income tax bands have remained static while wages have grown. At the same time those with savings have seen interest income rise as savings rates have increased.
Official figures from February show 4.2 million more workers pay income tax compared to just three years ago because of fiscal drag.
Tax thresholds have remained frozen since April 2021 and, as announced the Chancellor in his March Budget, will remain so until April 2028.
It has meant 1.6 million more people have found themselves in the 40% tax bracket.
The Institute for Fiscal Studies estimates a fifth of workers will be paying the rate by 2027.
Partner Alex Douglas said individuals with savings have also become victims of fiscal drag.
“Interest rate rises have meant they are getting more of a return,” he said.
“They should be paying tax on this savings income - it used to be deducted at source by the banks at 20% many years ago - but the only real mechanism for paying it now is by completing a tax return.
“The other issue is that, in the past, the basic state pension was well below the tax-free personal allowance that everybody gets so, even if retired, interest was usually covered by tax free personal allowances. However state pensions are almost using up tax-free personal allowances.”
Interestingly those with additional private pensions are potentially being pushed into the 40% tax bracket, something they have often not reached in their working lives.
Alex said: “Nothing has changed with regards to the tax principals, but it is so long since individuals with modest savings received meaningful interest that they probably won't be aware they should be paying tax.
“Perhaps the first they will know is an HMRC demand as savings institutions share information with HMRC so they will catch up eventually.”
Comment
“The best advice is to speak to RNS so we can assess if anything can be done to help with tax planning and, of course, complete a tax return so the tax is paid and HMRC don't chase causing you stress and potentially penalties.”
Clients may have relatives that have not considered this issue, or have ever even had to deal with HMRC and completing a tax return. Here at RNS we are always happy to have a free initial consultation with any new contacts to assess their circumstances and actions required, so do not hesitate to contact your usual partner.
Example 1
A retired worker in their late 60s with a state pension of £10,600 and gross bank interest on £100,000 of savings £5,000 will have a total income of £15,600. This is above the threshold at which 20% income tax is payable.
In previous years the £100,000 of savings may have only been generating £1,000 of income so no tax to pay, and no tax return submitted either.
The savings income now (£5,000) would mean a tax bill in the region of £400.
Example 2
A retired professional, in their 70s, has an index-linked private pension of £30,000 for the tax year that ended in April.
They have three other sources of income, state pension (£10,600), rental income (£7,000) and gross bank interest on £100,000 of savings (£5,000).
So their total income for the tax year is £52,600, pushing them over the higher rate threshold of £50,270 by £2,330.
In previous years with low interest rates the savings of £100,000 may have only generated income of say £1,000 on which the tax payable would have been minimal, and certainly not an income figure that pushed them into the higher rate (40%) tax bracket.