Brieifing Notes Order Of Taxation 680 392

Order of Taxation

Learn how different types of income are taxed and how they fit into a client’s income tax calculation.

In terms of income there are four main categories: non-savings non-dividend income, savings income (including offshore bond gains), dividend income and onshore bond gains. Onshore bond gains are classed as savings income but, due to the tax credit attached to them, they are taxed as the highest part of an individual’s income.

When dealing with clients with more than one source of income, it is important to understand the order in which each source is taxed.

Firstly, you need to consider non-savings non-dividend income. This includes employment income, self-employment income, pension income, rental income and some taxable state benefits for example state pension, jobseeker’s allowance, bereavement allowance.

Each tax year, almost every individual is entitled to a personal allowance. For this tax year it is £12,570 and it is reduced by £1 for every £2 of net adjusted income in excess of £100,000. It will therefore be zero when income exceeds £125,140.

An individual’s personal allowance is always set against non-savings non-dividend income first.

Secondly, you need to consider savings income and dividend income.

Savings income

Savings income can consist of interest payments from banks and building societies, corporate bonds, interest from a fixed interest fund (OEICs/ GIAs) and offshore bond gains.

Where an individual has both savings and dividend income, the amounts taken together are treated as the next part of their income, and the dividend income is taken as the highest part of the combined amount.

The first £5,000 of savings income (starting rate savings band) is taxed at 0%, if an individual has non-savings non-dividend income and this does not exceed the combined total of their personal allowance plus £5,000.

An individual also has a personal savings allowance which is currently £1,000 for a basic rate taxpayer, £500 for a higher rate taxpayer and £0 for an additional rate taxpayer.

Any savings income in excess of the allowances and starting rate savings band, if applicable, is taxed at 20%, 40% or 45%.

Dividend income

These are payments such as dividend payments from shareholdings or dividend distributions from OEICs and unit trusts.

The first £2,000 of dividend income is taxed at 0%. Any dividend income exceeding the £2,000 allowance up to the higher rate band is taxed at 7.5%. Any dividend income over the basic rate band is taxable at 32.5% or 38.1%.

If there is any unused personal allowance, it is placed against the savings and dividend income in the manner most beneficial to the individual. (section 27 Income Tax Act 2007)

The highest part of an individual’s income is onshore bond gains and termination payments from employment.

Order of taxation example 1

Order of taxation example 2

Points to Consider 

  • When calculating the £100,000 threshold for personal allowance, the whole bond gain is used.
  • If an individual had capital gains, exceeding the annual exempt amount, these sit on top of the individual’s taxable income to determine whether capital gains tax is chargeable at 10% or 20% (18% or 28% if residential property). When determining whether the individual is a basic or higher rate taxpayer for capital gains tax, the top-sliced bond gain is used.

Planning considerations

  • Make use of all available allowances in the most tax efficient way
  • Use a combination of tax wrappers to maximise available allowances
  • When considering surrenders of both offshore and onshore bonds in the same tax year, consider all available allowances

This briefing note is also available as a PDF

This is based on Canada Life’s understanding of applicable UK tax legislation and current HM Revenue & Custom’s practice, as at March 2021 and could be subject to change in the future. It is provided for professional advisers only. Any recommendations are the adviser’s sole responsibility.