Your coffee break investment plan - Day 4: The two enemies of investors: Inflation and tax
Inflation and tax are the two most hated enemies of investors. This dastardly duo has the ability to significantly reduce the value of your investment, although the good news is that some clever financial planning can reduce their power.
Let’s take each in turn. Inflation charts how the prices of goods and services increase over time. So, if your investments double in value over 10 years but the cost of living goes up by a similar amount then you’re no better off.
More worrying is if your investments lag inflation because this means the real value of your money will reduce over time and can leave you with a shortfall.
Justin Modray, founder of Candid Financial Advice, says: “Suppose you have £10,000 in a savings account paying 1.5% interest that you want to leave for a year before using to buy a car. Ignoring tax, this would be worth £10,150 after a year but if inflation is higher and pushes the car price to £10,300 you’d have to find an extra £150.”
At the very least, therefore, your objective should be for savings and investments to keep pace with inflation. “Inflation is calculated using the prices of many day to day items and services, but this simple example highlights the risks of lagging inflation,” he adds.
The effect of inflation on the value of £100
|Number of years||2% inflation||3% inflation|
|Day 1 real value||£100||£100|
|Source: Chase de Vere|
The impact of inflation eroding the value of savings has been endured by cash savers in the era of low interest rates over the past seven years, points out Patrick Connolly, a certified financial planner with Chase de Vere.
“Since then the returns from most savings accounts have been lower than the rate of inflation, meaning the real value of people’s savings has fallen,” he explains. “With little sign of an increase in cash savings rates, many people will continue to lose money in real terms.”
Moneywise can help you get the best rates on your savings.
But Mr Connolly suggests the best way to beat inflation in the long term is to hold a diversified investment portfolio of shares, fixed interest and property.
How to beat tax
You don’t have to be a millionaire to start protecting your money from the taxman. With just a little effort you shouldn’t have to pay very much tax on your investments at all.
For example, under individual savings account (Isa) rules you can invest up to £15,240-a-year in either a cash Isa or a stocks and shares Isa. With cash Isas you don’t pay tax on saving accounts interest, while with stocks and shares Isas there’s no tax to pay on income or capital gains.
Pensions are complicated but for longer-term requirements they are hard to beat due to the tax reliefs on the way in, the tax-free growth, and the fact you can take a 25% tax-free lump sum on retirement, says Tom McPhail, head of pensions research at Hargreaves Lansdown.
“If you are an employee you get the additional benefit of an employer contribution as well as your Government tax relief top up which means for every £1 you invest you can end up with £2 in your pot,” he says. “For most people a pension will be the core of their retirement saving.”
If you missed them last week, make sure you read the first articles in this series.
Also watch Moneywise editor Moira O’Neill interview Andy Parsons from The Share Centre about why you should start investing.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
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.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
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.