Fiscal drag happens when tax thresholds do not increase in line with pay. For example, you receive a 3 per cent pay rise, if the tax threshold has not then moved in line with this you could therefore be dragged into a higher tax bracket. Therefore, fiscal drag has the effect of raising government tax revenue without explicitly raising tax rates.
In the Spring 2021 Budget the then Chancellor, Rishi Sunak, announced that the personal allowance and the higher rate threshold would be frozen until 2025/26. This is now looking like it being extended for a further 2 years.
Frozen Pension Lifetime Allowance (LTA)
You start to pay income tax on annual earnings of more than £12,570, charged at 20%. You then pay tax of 40% on earnings over £50,270 a year, although the bands are different in Scotland.
These tax thresholds were already frozen until 2026, rather than going up in line with prices as you might normally expect. The Chancellor has now extended that freeze for a further two years. That means any kind of pay rise could drag you into a higher tax bracket. Even if it does not, it will almost certainly mean a greater proportion of your income is taxed.
Frozen Inheritance Tax Allowances
With the basic Inheritance Tax (IHT) threshold now also frozen at £325,000 until 2028 it’s expected that many more people will be caught out by IHT over the coming years as estate values, especially if your property value has increased over the years and/or investment returns, continue to rise.
Frozen Pension Lifetime Allowance (LTA)
The LTA, which governs how much can be saved in a pension before tax charges apply, still remains at its current level of £1.073m until 2025/26. This effectively sets the maximum tax efficient value of all your retirement benefits, assuming you have not already applied for any of the protections that are available. If your accumulated pension benefits exceed the LTA there is a tax charge which is 25% if the excess is drawn as taxable income and 55% if it is received as a lump sum.
Capital Gains & Dividends
The annual allowance before capital gains tax is paid will be reduced from £12,300 to £6,000 in April and then to £3,000 a year later. This tax is paid on the gains when you sell an asset, such as company shares or a second home.
The dividend allowance, if you own shares, before paying tax will be cut from £2,000 to £1,000 next year and then to £500 from April 2024. The allowance stood at £5,000 as recently as 2018.
How can you reduce the impact of the Fiscal Drag?
Doing nothing means that you are much more likely to pay increased levels of tax than would previously have been the case, whether that is in relation to income tax rates due to the frozen personal allowances, or other taxes, such as IHT or the impacts of the Pension LTA.
However, by engaging with a financial planner, there are still lots of legitimate and, depending on your personal circumstances, appropriate allowances, and tax reliefs available to you. For example, by making a pension contribution you can bring your income back down to the lower threshold to avoid paying higher rate income tax. However, deciding to make a pension contribution also then brings the consideration of which company you should make the contribution to and where is the most appropriate place for the funds to be invested in line with your attitude to risk and reward.
Aside from making full use of available allowances and reliefs, there are many other advantages to planning ahead, for example, by using your ISA allowance or making your pension contributions early in a new tax year you could benefit from extra potential growth, as well as receiving an element of your tax relief earlier on your pension and any pension contributions. Of course, there’s also the benefit of spreading your contributions over a tax year instead of in one lump sum at the end, when it might not be affordable to you at that time.
Planning ahead is essentially what good financial planning is all about. This will also help you to reduce, or even remove, the impacts of the “fiscal drag”.
At Armstrong Watson, our quest is to help our clients achieve prosperity, a secure future and peace of mind. We believe that for those people who are considering taking financial advice now may be a good time to do so to help utilise existing allowances and tax reliefs, which are still available, and could help to, depending on your personal circumstances, reduce the impacts of the fiscal drag on your finances.
For support and advice to help utilise existing allowances and tax reliefs, please contact our financial planning team.
