How to be a tax-efficient investor
It can be incredibly tough to make a decent return on your savings and investments these days - and when you do finally manage to turn a profit, the taxman will be poised to take his share of the proceeds.
The good news is you can prevent this happening - or at the very least, minimise the amount you have to hand over to HM Revenue & Customs - by taking advantage of some very effective, and completely legal, tax-efficient vehicles.
How is tax charged?
Let's start with understanding how tax is levied. The two principal forms of taxation you are likely to encounter are income tax and capital gains tax, although you might also want to consider the potential longer-term impact of inheritance tax.
We all have a personal allowance, which is the amount of income we can receive before paying income tax. In the current financial year this stands at £8,105, rising to £10,500 for those aged 65 to 74 and £10,660 for the over-75s.
The racier ways to avoid tax
Individuals with substantial tax bills to pay - and we are talking well into six figures - may want to consider venture capital trusts (VCTs) and enterprise investment schemes (EISs). While a step too far for most investors given the risks in the underlying assets, they can sometimes have a role to play.
VCTs invest in entrepreneurial businesses at an early stage. This means the investment may be high risk and speculative in nature but can end up delivering some spectacular returns, which makes them appealing for those with plenty of spare cash.
Income tax rebates of up to 30% are available to investors - if you put in £100,000, for example, you could end up seeing £30,000 knocked off your end-of-year tax bill. Up to £200,000 a year can be invested in VCTs but you must hold on to the shares for at least five years in order to keep your rebate. And when you dispose of your VCT, any gains will be exempt from capital gains tax.
EISs are similar to VCTs but arguably even riskier because your money will be invested in the shares of a single company rather than a fund. An income tax rebate of 20% is given on investments of up to £1 million, provided the shares are held for at least three years.
The tax owed on amounts above that will depend on your overall income. For example, it will be 20% on anything up to £34,370 and 40% if it's between £34,371 and £150,000. Those with taxable earnings above £150,000 will pay 50%, which is known as the additional rate.
Savings interest normally has 20% tax deducted before you receive it and this will cover most people's liabilities. However, higher-rate (40%) taxpayers or those in the 50% bracket will owe tax on the difference, which will be paid through a self-assessment form. And those on very low incomes may be able to claim some of the tax back.
The rules for dividend income are slightly different. Companies pay you dividends out of the profits on which they have already paid - or are due to pay - tax. The confusingly titled 10% dividend tax credit takes account of this and enables the shareholder to offset against income tax. Due to the complicated calculation, basic-rate taxpayers have nothing more to pay, while those higher and additional-rate taxpayers will owe 22.5% or 32.5% of the gross dividend, respectively.
Capital gains tax is payable on the gain or profit made when you sell or give something away. It applies to most assets you own, including shares and property, but not your car, personal possessions disposed of for up to £6,000 and, usually, your main home.
Everyone gets an annual tax-free allowance - currently £10,600 - and this will generally be fine for most people. However, if your gains exceed this amount then you will pay 18% if you earn less than £34,370 a year or 28% if you pay tax at the higher or additional rate.
How can I pay less tax?
The next question is how to reduce your tax burden. The good news is there are a number of totally legal solutions that enable you to keep hold of your money - without resorting to some of the morally questionable schemes that got the likes of comedian Jimmy Carr in the headlines.
The first port of call for anyone should be individual savings accounts, more commonly known as ISAs. These were introduced back in 1999 to encourage more people to save, and they have proved hugely popular as any gains that are generated are free of both income and capital gains tax.
There are two types of ISA: cash ISAs and stocks and shares ISAs. Cash ISAs, which are open to any UK residents over the age of 16, are tax-free savings accounts that are available from banks and building societies. You can deposit up to half your annual ISA allowance in a cash ISA, which means a maximum of £5,640 in the current tax year.
To open a stocks and shares ISA you need to be aged at least 18. Here you can protect more money from the taxman as you can invest up to £11,280 this tax year. Stocks and shares ISAs have the potential to generate higher returns than cash ISAs but they are more risky as your capital can fall if your stockmarket investments drop in value.
The main benefit of a cash ISA is you will earn interest in exactly the same way as with a standard savings account, but the taxman won't take a cut.
For example, the value of £10,000 sitting in a cash ISA earning 3% gross interest would be £14,802 after 10 years, according to financial adviser AWD Chase de Vere. However, if it was in a straightforward savings account that total would shrink to £13,702 for a basic rate taxpayer and £13,491 for those paying 40%. That equates to tax savings of £925 and £1,826, respectively.
The effect of tax on your cash
The table below hows what a big difference tax can make to your investments over time.
But there are ways to avoid it completely, with cash ISAs, growth equity ISAs and pensions invested in growth funds.
However, due to that 10% tax on dividends whenever you invest for income, whether it is in an ISA or a pension you will still lose some money to the taxman.
A pension is another extremely tax-efficient tool. Investments in a pension are taxed in exactly the same way as they are in an ISA. You can't reclaim the dividend tax credit but gains enjoyed on the likes of cash, property, bonds and equities are free of income and capital gains tax.
You also receive tax relief from the government as your money enters your pension. For example, the net cost to you of a £1,000 contribution will be £800 if you are a non or basic-rate taxpayer, £600 if you pay at the higher rate and £500 if you are an additional rate payer.
On the downside, you cannot get access to your pension until you retire - at which point the first 25% can be taken, tax-free in cash, with the balance being subject to taxation, depending on the retirement income option chosen.
Other tax-planning measures ISAs and pensions are the two most suitable tax-efficient vehicles for the vast majority of people, after which they should consider some other investment planning techniques to reduce their potential burden.
For example, husbands and wives - as well as civil partners - are taxed independently so each will have their own personal allowances. Therefore, if one partner has a different tax rate to the other it's worth considering moving assets to the lower taxpayer to reduce the overall tax burden.
For example, if a couple has £100,000 in a deposit account that's paying 3% interest - £3,000 a year - this would be subject to 40% tax in the higher taxpayer's name, which would be £1,200. However, if the money was held in the non-taxpaying partner's name, this would reduce to zero.
If your total estate is worth more than £325,000 then your estate will be liable for inheritance tax when you die. But there are lots of allowances around inheritance tax that can be utilised, including an annual gift allowance and gifts out of income. In addition, there are a number of very useful trust options for tax-planning purposes, in which one or more trustees are made legally responsible for holding assets.
Using trusts in conjunction with your savings and investments can make real sense to ensure the right person receives the money at the right time - but this is an extremely complicated area so you will need to seek professional advice.
Open a free research account
Subscribe to Moneywise
Subscribe for just £1 and receive 3 issues
New subscribers take advantage of this fantastic deal with moneyback guarantee if you decide Moneywise is not for you.