Keep your profits away from the taxman
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 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 selfassessment 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.
For more investment advise, why not visit the Moneywise Investment School
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 advisers AWD Chase de Vere. However, if it was in a straight-forward 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.
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.
The effect of tax on your cash
The table below shows 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.
|PRODUCT||TAX POSITION||FINAL FUND VALUE AFTER 10 YEARS ON £10,000||TOTAL TAX PAID|
|SAVINGS ACCOUNT||20% TAXPAYER||£13,702||£925|
|SAVINGS ACCOUNT||40% TAXPAYER||£13,491||£1,826|
|SAVINGS ACCOUNT||50% TAXPAYER||£13,386||£2,268|
|EQUITY INCOME FUND||NON OR 20% TAXPAYER||£14,243||£471|
|EQUITY INCOME FUND||40 TAXPAYER||£13,035||£1,470|
|EQUITY INCOME ISA||N/A||£14,243||£471|
|EQUITY INCOME ISA||N/A||£14,802||£0|
|PENSION EQUITY INCOME***||20% TAXPAYER||£17,804||£589|
|PENSION EQUITY INCOME***||40% TAXPAYER||£23,738||£786|
|PENSION GROWTH***||20 TAXPAYER||£18,503||£0|
|PENSION GROWTH***||40 TAXPAYER||£24,671||£0|
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 offyour 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 levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Venture Capital Trusts were introduced in 1995 to encourage private investments in the small-company sector by offering tax relief in return for a minimum investment commitment of five years. A VCT is a company, run by a fund manager, which invests in other companies with assets of no more than £7m that are unlisted (not quoted on a recognised stock exchange) but may be listed on the Alternative Investment Market (AIM) or plus with the aim of growing the companies and selling them or launching them on the stock market. Investors in new VCTs are offered desirable tax advantages and VCTs themselves are listed on the London Stock Exchange, with strict limits laid down by HM Revenue and Customs on what they can invest in and how much they can invest.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.