National Insurance Guide

Introduction

Read my lips: no more taxes.

How many of us have listened to politicians of various hues utter variants of the words above – only to discover that, by some mysterious sleight of hand, the government has picked our pockets yet again?

In recent years, National Insurance Contributions (NICs) have emerged as the main contender as the tax that “dare not speak its name”.

While politicians promise solemnly not to raise levels of income tax and, in fairness, they generally keep their word, they try to get the same money by upping the rate of NICs we pay.

Officially NICs are not a tax but a contribution towards benefits. But in the world of “duck theory” – if it looks like a duck, walks like a duck and quacks like a duck, it’s a duck – NICs are undoubtedly a tax.

What is National Insurance?

National Insurance was introduced in 1948 to provide funds for the provision of welfare benefits such as retirement pensions and sickness and unemployment benefits.

In theory, it remains the basis of state benefits such as maternity benefit and widows’ pensions. In practice, a potpourri of income tax, NICs and other revenue-raising methods funds all benefits.

How much you pay

Here are the basic facts:

• Contributions are tied to a lower and upper earnings limit

• The upper earnings limit is the amount of income that is assessed for your National Insurance contributions

• Therefore, if the upper limit is increased, you are liable to pay more National Insurance

• For the 2008-2009 tax year, National Insurance is payable on earnings between £105 per week (£5,460 a year) and £770 a week (£40,040 a year). For 2009-2010 this is set to rise to £110 per week (£5,720 per year) and £844 per week (£43,888 per year)

• Until April 2003, no matter how much you earned, earnings above the upper limit were not subject to National Insurance

• All employees paid 10 per cent on earnings between those two limits, while the self-employed (who are entitled to less state benefits) paid seven per cent

• From 6 April 2003, this has changed. Since then, employed people pay 11 per cent, while the self-employed pay eight per cent

• In addition, earnings above the upper limit of £40,040 face an additional one per cent charge

Effectively, this raises the higher rate of tax from 40 to 41 per cent. Moreover, in the March 2007 Budget, the “alignment” of NICs to income tax was given fresh impetus by the government (see below).

What types of National Insurance are there?

As if to complicate matters further, there is no single scale of National Insurance but several:

Class 1: Employees (with earnings above £100 a week) pay this. The amount they pay is based on the income above the lower and upper earnings limit, plus the extra 1 per cent for those earning over £34,840. Employers are also required to pay NICs on behalf of their employees.

Class 2 Contributions are paid by the self-employed, but not people whose income is below £4,635 in the current tax year (2007-2008). It entitles the contributor to most social security benefits but not unemployment, invalidity or widows pension and is set at £2.20 a week in 2007-2008.

Class 3 Contributions are voluntary. They are paid by those who do not earn enough to pay Class 1 or Class 2 contributions but would like to top up their benefit entitlement so that they can enhance the value of their state pension. The Class 3 rate is set at £7.80 a week.

Class 4 Contributions are paid by the self-employed. They are set at 8 per cent on earnings between £5,225 a year and £34,840 a year, plus 1 per cent on earnings above that amount. The self-employed receive no extra social security benefits for paying Class 4. However, they receive some tax relief on Class 4 contributions.

The most common types of National Insurance are Class 1 and 4.

The 2007 Budget Changes

Until now, the level at which NICs continue to be paid at 11 per cent (or 8 per cent for the self-employed) and the 40 per cent tax rate begins to bite have been different.

The 11 per cent rate finished “earlier” and just 1 per cent was raised on earnings above that. However, the Chancellor announced in his March 2007 Budget that from April 2009 the thresholds for income tax and NIC will become “aligned”.

This means that instead of having separate cut-off points the two – income tax and NICs – will be the same.

The earnings level at which the 40 per cent tax will hit will increase to £43,000, including the basic earnings allowance on which no income tax is paid. But so will levels of NI contributions.

So from 2009, you will pay 11 per cent NICs on earnings from about £5,225 up to £43,000. This could add more than £500 to your annual NI bill.

The Treasury forecasts that making NICs more like income tax will raise receipts by nearly £1.5bn by 2009.

Does anyone not pay National Insurance?

Aside from those not working, the other category that does not pay National Insurance is people of retirement age.

The exemption applies not just to pension income but also earnings from any work carried on past retirement age.

How to reduce the effect of National Insurance Contributions

There are not many ways of doing this.

• Salary sacrifice: one of the more popular methods is “salary sacrifice”.

This is where an employee foregoes an increase in his or her salary in return for increased employer contributions into an occupational pension.

Pension contributions are not subject to NI.

Salary sacrifice offers benefits for employers since they are also not liable to pay NI on contributions into a pension scheme.

• Set up a limited company: if you are self-employed and set up a limited company, you can pay yourself dividends instead of an income, thus avoiding National Insurance. You may still wish to pay yourself a minimum income in order to qualify for state benefits, payable to those who make NICs.

However, your company may be liable to a range of other taxes, so it is important to take professional tax advice first.