Fiscal drag happens when tax thresholds do not increase in line with pay.
For example, you receive a three 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.
So, whilst the announcement in the Spring Statement to raise the threshold for paying National Insurance was welcomed, alongside the ‘carrot’ dangled of the Chancellor’s plan to reduce the basic rate of income tax from 20p to 19p in 2024, fiscal drag is going to have a significant impact on millions of taxpayers in several other ways, unless they take the time to look carefully at various aspects of their financial and tax planning.
Frozen Personal Allowances
In the 2021 Spring Budget the Chancellor announced that the personal allowance and the higher rate threshold would be frozen until 2025/26, which is now forecast to raise £2.77 billion in 2022/23, rising to £13.04 billion in 2025/26 as wages increase alongside inflation (though not necessarily at the same rate).
Frozen Inheritance Tax Allowances
With the basic Inheritance Tax (IHT) threshold now also frozen at £325,000 until 2026 it is expected that many more people will be caught out by IHT over the coming years as estate values, supported by increased property prices and/or investment returns, continue to rise.
Frozen Pension Lifetime Allowance (LTA)
This governs how much can be saved in a pension before tax charges apply and will also remain at its current level of £1.073m until 2025/26. This 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 per cent if the excess is drawn as taxable income and 55 per cent if it is received as a lump sum.
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, 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 to help reduce the impacts of the fiscal drag on your finances.
To discuss how we can help contact Paul Moody on 01768 222030 or email paul.moody@armstrongwatson.co.uk
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