Soaring inflation means tax breaks are less valuable. Find out why here

While many tax allowances haven’t fallen, they haven’t increased in line with inflation either. In real terms, that means they’re less valuable than they once were. It could affect your income, long-term wealth, and what you leave behind for loved ones.

As the cost of living and the value of some assets rises, the tax breaks you use may not be stretching as far. It means your tax liability may have increased or that you need to review your financial plan.

As potential Inheritance Tax (IHT) bills consider the total value of your estate, the associated allowances can really highlight the effect of inflation. 

The nil-rate band would have increased by more than £135,000 if it matched inflation

The nil-rate band is the threshold for paying IHT. If the total value of your estate is below this, no IHT will be due.

For the 2022/23 tax year, it is £325,000. It’s remained at this level for 13 years. However, according to a report in the Telegraph,  if the allowance had kept pace with inflation, it would be worth more than £462,000 today. It would mean that families could leave loved ones more than £135,000 extra without having to worry about IHT.

Yet, while the allowance has been frozen for more than a decade, many of the assets you want to leave behind are likely to have increased in value significantly. 

According to the Land Registry, at the start of 2009, the average home in the UK was worth almost £158,000. 13 years later, the average property price had risen to almost £275,000. As a result, property alone will now use up a significant proportion of the nil-rate band.

If you’re leaving some property, including your main home, to children or grandchildren, you can take advantage of the residence nil-rate band to increase how much you could pass on free from IHT. For the 2022/23 tax year, this is £175,000.

However, both the nil-rate band and residence nil-rate band are frozen until 2028. So, in the current high inflation environment, the value these allowances provide in real terms is likely to fall.

Many of the allowances you can use to pass on assets during your lifetime to reduce IHT haven’t increased either. Assets may be considered part of your estate for up to seven years for IHT purposes, so these allowances could be a vital part of your financial plan.

Among those that haven’t increased are: 

  • The annual exemption means you can pass on up to £3,000 worth of assets each tax year without the sum potentially being added to the value of your estate. However, if it had increased in line with inflation, it would be more than £10,000 today. 
  • Parents can gift their children up to £5,000 on their wedding day without considering IHT. If this allowance had increased at the same pace as inflation, it would be worth almost £35,000 in 2022. 

So, while the allowances you make use of may not have changed, the value they add to your financial plan could have fallen. 

It’s not just IHT where frozen allowances could be affecting your wealth and tax liability either. 

3 other allowances that may not be as valuable due to inflation

1. Income Tax thresholds

While the Personal Allowance threshold has increased significantly over the last decade, the higher- and additional-rate Income Tax thresholds haven’t increased at the same rate of inflation. As a result, if your salary has risen, your tax liability is likely to have risen too. 

According to Quilter, if Income Tax thresholds remained frozen for the next five years, someone earning £35,000 would be around £2,000 worse off over the five years. For someone earning £50,000, this rises to more than £9,000. 

During the autumn statement, chancellor Jeremy Hunt announced the income for paying the additional rate of Income Tax would fall from £150,000 to £125,140 in the 2023/24 tax year. As a result, high earners may see their tax liability increase. 

2. Dividend Allowance

Dividends can be a way to boost your income. If you’re a company owner, you may choose to take dividends as payment to supplement a salary, or you may invest in dividend-paying companies.

For the 2022/23 tax year, you can take up to £2,000 in dividends before tax is due. This compares to an allowance of £5,000 a decade ago. Once you factor in inflation, the value the Dividend Allowance offers falls even more sharply.

The Dividend Allowance will fall to £1,000 in 2023/24 and to £500 in 2024/25.  

3. Pension allowances

Both the Lifetime Allowance and Annual Allowance have fallen in the last decade. Again, when you consider inflation, the reduction in value becomes even starker and it could have a significant effect on your retirement savings.

The Annual Allowance limits how much can be added to your pension during a tax year while retaining tax relief. For the 2022/23 tax year, the maximum Annual Allowance is £40,000, and some savers may have a lower allowance. This compares to a maximum allowance of £50,000 in 2012/13.

Similarly, the Lifetime Allowance, which caps the total value your pension can be while retaining tax efficiency benefits, fell from £1,500,000 in 2012/13 to £1,073,100 in 2022/23. 

Making inflation part of your financial plan

When you are making long-term plans, inflation is important to consider. From the value of allowances to how to manage your savings, the rising cost of living may affect your decisions.

Please get in touch with us to discuss how to make inflation part of your decision-making process.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The Financial Conduct Authority does not regulate estate or tax planning. 

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The value of investments and any income from them can fall as well as rise and you may not get back the original amount invested.

Past performance is not a guide to future performance and should not be relied upon.

HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.


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