Going, going... not quite gone

By John Whiting Tax partner, PricewaterhouseCoopers LLP

In his final Budget as Chancellor in March 2007, Gordon Brown made various changes to the income tax system.

Many of these come into effect from April 2008.

One of the proposals was to abolish the 10% income tax rate band, in part to pay for the reduction in the basic rate of income tax from 22% to 20%.

In the fine print was a commitment to keep the 10% rate for savings income - but how will this operate?

Currently, the first �2,230 of income above one's personal allowance is taxed at the 10% tax rate.

Income above that level is then taxed at 22%, with the 40% higher rate coming into effect after a further �32,370 of basic rate income.

Winners and losers

From 6 April 2008, the 10% rate disappears and so the income above the personal allowance is taxed at the new 20% basic rate.

This gives winners and losers. Anyone with income above about �18,500 gains enough from the 2% reduction in the basic rate band to compensate for the loss of the 10% band.

Those with lower incomes are compensated by higher personal allowances for those aged 65+, higher working tax credits or the 10% rate staying on some savings income.

Unfortunately that leaves some people out of pocket - early retirees (who won't get the higher allowances) and younger workers (including students) as WTCs don't apply until age 25.

Savings income

As far as savings income - and this article will deal just with bank/building society interest for simplicity - is concerned, there are slight variances.

Interest normally comes with tax deducted at source at 20%.

The rate of tax on savings income is currently 20% for basic rate taxpayers (not 22%).

So the tax deducted at source satisfies the basic rate taxpayer's liability but leaves the higher rate payer to pay more (the savings income is treated as the 'top slice' of income).

If the individual only has a very modest income, then the savings income will fall into the 10% tax bracket and generate a repayment of tax.

Tax repayment

To take a simple example, suppose someone has part-time earnings of �6,000 and bank interest of �1,000.

That gives total income of �7,000, of which �5,225 is covered by the personal allowance, leaving �1,775 to be taxed.

All of that falls into the 10% tax band and so tax of �177.50 will be due on the combined income.

Tax of �200 will have been deducted from the bank interest so the individual is due a tax repayment of �22.50 - or more if they have also had tax deducted under PAYE from their earnings.

Slight catch

From 6 April 2008, whilst the 10% tax rate is being abolished generally, it will remain in place for savings income.

There is a slight catch here with the savings income always being treated as the 'top slice' of income.

So someone with a salary of �30,000 and interest income of �1,000 won't benefit from this continued 10% rate.

Their savings income will just be taxed at 20%, normally satisfied by the tax deducted at source by the bank.

Tax credits

But returning to the example above, the �1,000 of bank interest will fall into the notional 10% tax band on savings income and be taxed at 10% - thus potentially still generating a repayment.

The income from the part time job above the personal allowance will be taxed at 20%, not 10% as currently.

Consequently the overall tax bill would be �255 (i.e. �1,000 @10% plus �775 @ 20%) - though the additional factor is that personal allowances also will go up from April (to �5,435) and so the final bill will be �213 (i.e. �1,000 @ 10% plus �565 @ 20%), not as bad as �255 but still an increase on the current bill.

Many such low earners (but by no means all) will be compensated by higher tax credits.

It has to be emphasised that the above comments are based on the various announcements from HM Revenue & Customs (HMRC) and HM Treasury - we don't yet have the precise rules for how the 10% savings rate will continue to operate, so watch this space for any changes.

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