How much tax do you pay on your investments? As investors face an increasingly complex and changing set of tax rules, the cost of choosing the “wrong” savings vehicle can be very large.
Yet those who time their income carefully and make use of all the available tax breaks can end up paying relatively little. Indeed, it is possible to live comfortably on savings while paying almost no tax at all, according to James Hannam, a tax consultant at EY, a professional services firm.
Remarkably, he calculates that it would be possible for a couple to have an income of £120,000 a year and pay less tax than someone earning the average wage, based on nothing more elaborate than tax-free allowances, sharing assets between spouses and a history of using individual savings accounts.
Of course, being able to withdraw money tax free from a savings pot is not the full story. It also matters how much tax is levied on the original funds — and on their investment returns.
Take pensions, for example, where the tax incentives are given up front and income is mostly subject to income tax. They are more tax efficient than any other mainstream form of saving, according to Stuart Adam of the Institute for Fiscal Studies. At the other end of the scale, buy-to-let housing is “about the most tax-penalised form of investment you can make”.
More changes might be on the way. Politicians have reason to be nervous of a backlash if they try to increase politically sensitive taxes on property, inheritances and pensions. Even so, plenty of people think the tax system has not kept pace with either the growth in total wealth or its increasingly unequal distribution. Mr Hannam said: “From a fairness point of view I think tax on savings is much lower than it should be.”
But others argue that at least some of the returns on savings — if they have already been taxed — should be free of tax. Mr Adam favours reform, but adds: “If you want to spend money tomorrow rather than today, why should the tax system penalise you?”
Taxes are not the only costs to be considered. Fees can also make a big difference — in many cases their impact is even greater than tax. An annual charge of 1 per cent on funds can have an effect broadly comparable to charging basic-rate income tax on returns, according to the Institute for Fiscal Studies.
Even so, to focus on tax and charges might miss the big picture. A more important question might be whether or not the investment is likely to offer good investment returns. Robert Lockie of Bloomsbury Wealth says: “If you are talking about making an investment it has to stack up on its own merits rather than on its tax advantages.”
That said, taxes and charges can significantly change the relative attractiveness of different savings options. Here are 10 ways — some complex, some straightforward — to save more tax efficiently.
1 Savings allowance
Large cash deposits are extremely inefficient, from a tax perspective. Since the tax rules make no allowance for rising prices, effective tax rates on the interest earned on cash is highly sensitive to inflation. But since April 2016, about 95 per cent of taxpayers have no tax to pay on their savings income. The introduction of a “personal savings allowance” has meant no tax on savings income up to £1,000 for basic-rate taxpayers. Higher-rate taxpayers get a £500 savings allowance, while additional-rate payers get none.
There is also a 0 per cent starting rate for savings for those on very low incomes whose non-savings income is below a £16,500 threshold. The bonuses on Save As You Earn schemes, the savings-related share schemes, are also tax free.
2 Individual savings accounts
The scope for tax-free saving has increased with the April 2017 rise in the individual savings account (Isa) limit to £20,000. The restrictions on holding cash versus shares in them have also been relaxed. And the options for tax friendly savings were expanded with the ability to hold peer-to-peer loans in the new Innovative Finance Isa, shielding the interest repaid by borrowers from tax.
These tax-privileged accounts date back to former chancellor Nigel Lawson, who introduced the personal equity plan (Pep) to encourage equity ownership among the wider population in 1987, with a maximum investment of £2,400.
Anyone who squirrelled away the maximum allowed under Peps and then Isas, which replaced them in 1999, would now have saved around £250,000. While investment returns have varied widely, a growing group of investors now have over £1m in their Isa tax shelter.
3 Premium bonds and other winnings
Tax-free savings certificates are not currently available from National Savings & Investment, the state-owned savings bank. But NS&I offers premium bonds that give holders the chance to win tax-free cash prizes of between £25 and £1m in a monthly prize draw.
The interest rate used to determine the annual prize fund is 1.4 per cent, although investors — who can buy up to £50,000 of bonds — should not expect their returns to match that. Small savers would be better off making use of Isas and the savings allowance, advisers says. But the tax-free prizes mean they can be a good bet for big savers who are higher- or additional-rate taxpayers. Lottery, football pools and other betting winnings are also free of tax.
4 Stocks and shares
The taxation of dividends was overhauled in April 2016 and is set to change again in April. As well as scrapping the old tax credit and introducing a new £5,000 dividend “allowance”, it introduced higher rates of dividend tax: 7.5 per cent for basic-rate taxpayers, 32.5 per cent for higher-rate taxpayers and 38.1 per cent for top-rate taxpayers.
Next month, the tax-free allowance for dividend income will be cut from £5,000 to £2,000. While the 2016 changes left about 700,000 taxpayers facing tax rises, the coming reforms will affect nearly 2.3m more.
But capital gains on investments are relatively lightly taxed. Higher- or additional-rate taxpayers pay a rate of 20 per cent on most gains, while basic-rate taxpayers pay at half the rate. A tax-free allowance of £11,300 can be deducted from total taxable gains. Gilts and many corporate bonds are exempt from capital gains tax, if held directly rather than through a fund.
Pension tax breaks remain very generous, even though the amount that can be saved this way has been significantly reduced. Indeed the IFS says that the NICs relief on employer pension contributions — taken together with the 25 per cent tax-free lump sum — means that an employee receives as much pension income as if they had saved in an Isa with only 70 per cent of the cost in upfront income. Pensions can also be a tax-efficient way of handing on wealth, particularly for those who die before they are 75.
But high earners are increasingly restricted in their pensions savings. The annual allowance for those with total earnings of more than £150,000 has been whittled down from the standard £40,000 to a floor of £10,000 for those with income of £210,000 or more. The lifetime limit has fallen from a high of £1.8m at its peak to a £1m limit in this tax year.
Buy-to-let landlords have found themselves in the Treasury’s sights. Since April 2016, they have been required to pay a 3 per cent stamp duty land tax surcharge. At the same time, landlords were denied a CGT rate cut introduced for other assets and their “wear and tear” allowance was abolished. A year later, a cut in the tax relief available for landlords’ mortgage interest started to be phased in.
This significantly reduced the appeal of buy-to-let housing, according to the IFS. For a 10-year buy-to-let investment 50 per cent financed by a mortgage, the effective tax rate for a higher rate taxpayer will increase from 47 per cent to 76 per cent, it calculated.
By contrast, owner-occupied housing is just as tax-efficient as investing in an Isa. This dates back to decisions in the early 1960s to abolish the annual levy on “imputed” rent of homeowners and to exempt housing profits from capital gains tax.
The tax advantages of owner-occupied property have further increased recently with the phasing in of a new inheritance tax allowance and the launch of the Lifetime Isa (Lisa) which is aimed at helping young people save for their retirement or to buy a home. It allows the under-40s to save up to £4,000 a year and receive a government bonus of 25 per cent.
There are extra allowances for people who get rental income from their property. If you have a lodger in your home and claim rent-a-room relief, the relief has been increased to £7,500 from 2016/17. Since April 2017, there has been another a tax-free allowance of £1,000 for property income.
7 Tax-advantaged venture capital schemes
Venture capital schemes have emerged as popular options for wealthy investors “capped out” of pensions savings. They are, however, a high-risk investment. Unless you are willing to lose money, experts say you should steer clear.
There are four schemes designed to help small- or medium-sized companies and social enterprises grow by attracting investment. They offer income tax and capital gains tax reliefs; for venture capital trusts, dividends are also free of tax.
The main schemes are Enterprise Investment Schemes and Venture Capital Trusts, which offer income tax relief at 30 per cent of the amount invested. The Seed Enterprise Investment Scheme offers income tax relief at 50 per cent of the cost. An individual can invest up to £1m a year in an EIS company, up to £100,000 in an SEIS company and a maximum of £200,000 in a VCT.
There is also a tax break — the Social Investment Tax Relief — to encourage people to support social enterprises.
8 Family investment companies
A growing number of wealthy investors have set up “family investment companies” (FIC) to take advantage of the growing gap between corporate and personal tax rates. Instead of investing this in their own name, investors loan cash to an FIC, free of interest, for it to invest in assets such as stocks and shares. Typically, parents hold voting shares and children hold shares with dividend rights, reducing the tax paid on dividends and potentially reducing inheritance tax bills.
9 Trusts and partnerships
Generally speaking, trusts have become increasingly heavily taxed though the tax paid by trusts varies depending on their type. Even so, trusts are still used for tax planning, as it is often possible to make use of the beneficiaries’ unused income tax and capital gains allowances.
For example, grandparents can transfer money into a trust — and name the children as beneficiaries. The income generated by the assets can be paid out for school fees — or other purposes — in a way that makes use of a child’s personal allowance, which is currently £11,500.
Some advisers promote family limited partnerships as a more tax-efficient alternative to trusts. But, as with trusts and family investment companies, set-up and administrative costs can be high.
10 Investment bonds
Investment bonds — lump sum investments that provide an element of life cover — used to be heavily marketed in the days of commission-driven sales. The big fines levied on banks for mis-selling these products show they are not suitable for everyone.
Even so, the bonds, which invest a lump sum until the bond is either cashed in or until the death of the last life assured, have their uses. They are particularly useful for people who want to defer tax bills as they are subject to a distinctive set of tax rules.
The profit on the bonds is taxed as income when it is realised. In the meantime, the bonds do not produce income, even though it is possible to withdraw up to 5 per cent of the original investment tax-free each year. The lack of taxable income can be a boon for an investor wanting to avoid a high marginal tax rate. Graeme Robb of Prudential says: “If you are a higher-rate taxpayer, it might be useful to turn off the income tap and put into something non-income producing.”
The bonds are usually excluded from the means test carried out by local authorities when working out how much someone needing care will need pay — except in cases where avoiding care fee was a motive for the investment. Trustees often use bonds to simplify the administration of a trust, as they do not produce income that needs to be reported to HMRC.
But investors need to take advice before cashing in the bonds, advisers say. Ian Dyall of Tilney Financial Planning says: “Bonds are easy to administer. All the complexity is around the exit strategy.”
The tax consequences of making a “partial withdrawal” from policy segments will be different from cashing them in entirely. Ticking the wrong box can have catastrophic results, as an unfortunate taxpayer who was asked to pay tax at a rate of 779 per cent on his life savings found a decade ago. Facing bankruptcy, he eventually persuaded the courts to rule that his mistake could be rectified.
The government has since changed the rules so that “wholly disproportionate” gains can be recalculated. But it only expects to do this in a handful of cases. Savers should remain on their guard, advisers say. Rachael Griffin, financial planning expert at Old Mutual Wealth, says: “Policyholders need to take due care and attention to ensure they carry out withdrawals from their bond in the right way, first time, as there is still no guarantee that any mistake can be corrected.”
This article has been corrected to clarify the tax-free limits on the personal savings allowance.