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Income Investor: don't pay too much tax

Minimising the tax you pay – within reason and as opposed to tax evasion – should be part of your lifetime investment strategy.

 
Income Investor: don't pay too much tax

Tax avoidance is in the news – relating to celebrities, BBC employees and large US companies operating in the UK. But tax avoidance – within reason and as opposed to tax evasion – should be part of your lifetime investment strategy.

Now, I don’t mind paying my fair share, but it does rankle when my tax money seems to be methodically wasted, which sadly seems to be the norm. Tax, like inflation, eats away at your capital and income and you need to have a pro-active strategy to deal with it.

Why minimise tax?

My justification for avoidance is two-fold:

  • The taxman gets a lot more than you think: I once calculated that for every pound of taxed income from employment spent on something liable to VAT, the taxman might receive 85p or more.
  • Legal tax concessions have been created by Parliament to encourage specific behaviours that are considered to be good for society.

This is a big subject, so I will have to skate across some of the details (and ignore some of the more esoteric tax concessions) and assume that most readers will be familiar with the basics of how the tax system works in the UK and the tax benefits offered by ISAs, Sipps and other pensions. For investors, the main avoidable taxes are income tax, capital gains tax (CGT) and inheritance tax (IHT).

Think about retirement

A substantial proportion of an investor’s lifetime will be spent in retirement, so any lifetime tax avoidance strategy must consider tax in retirement. One of the major constraints is that pension funds built up by one person cannot be transferred to provide a pension for someone else (at least while the original fund holder is still alive).

Most investors will be married and this is where many of the legal concessions are available: you can distribute assets and investment income to your spouse in the most efficient way. You can also bequeath everything, free of IHT, to your spouse (although there might be an IHT liability when the spouse dies). So – perhaps perversely – getting married might be seen as a major part of your tax planning!

The right mix

Next you should develop a strategy in the way you use ISAs, Sipps and other pensions (I am excluding drawdown pensions and ‘final salary’ pensions in this simplified description). The key difference between ISAs is of course that ISAs house taxed income that is NOT taxed when you take it out, while Sipps and pensions refund income tax when you put the money in but tax it when you take it out.

Here is my take on this:

  • Make the most of any company pension scheme offered by your employer (who may well make additional contributions to your pension or offer a ‘salary sacrifice’ scheme)
  • Contribute any income taxed at a higher rate to a pension (40% or more tax refund when you pay in, potentially 20% or less when you take out income in the form of an annuity)
  • Putting income taxed at 20% into a pension has little advantage over an ISA – therefore put most of income taxed at the basic rate in ISAs, for yourself and spouse

In retirement (hopefully early retirement), I have calculated assuming that you have the promised £10k personal tax allowance, and assuming a basic annuity rate of around 5% and a tax-free lump sum of 25% you might have a pension fund of around £266k without incurring any tax liability in retirement  (£266k less 25% is £200k).

Only have a larger pension fund if this is built up with income taxed at a higher rate or if you apply a further tweak and take out a more complex kind of annuity, such as one that will rise with inflation (and with the income tax allowance) or one that will also pay a pension to the surviving spouse, when the original pension holder dies. This will result in an initially lower pension from a larger pension pot.

Inheritance tax

And once you are retired you can avoid eventual IHT by gifts to family and charities, including paying into pensions for your spouse and kids. What is more, if you are optimistic about continued good health in retirement, you might even be able to pay into a new pension for yourself, from your investment income, giving you an additional 25% tax boost on this money when you take your annuity at 75.

But a word of caution: everyone’s situation is different, so make sure you research your own specific lifetime tax strategy or discuss it with a qualified adviser.

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7 comments so far. Why not have your say?

pkora94

Nov 22, 2012 at 12:42

Increase pension contributions and if you have kids your child tax credits go up but will the tax man be ok with it? To retire at 55 i need to seroiusly increase my pension contributions but the child tax credits went up last year as well, is this legal??

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Income Investor

Nov 22, 2012 at 14:32

pkora

You might look on some benefits as negative tax payments, which provides a whole other dimension to the discussion!

I'm not an expert but I understand that the household income you need to declare for Child Tax Credit (and many other 'benefits' such as Student grants, etc.) specifically excludes any income earned inside an ISA (but would obviously include any pension income).

(The author)

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Bryan Jefferson

Nov 22, 2012 at 16:09

What about dividend income for shares held within an ISA? Isn't that taxed before it is paid into your ISA (or transferred to your personal account)? If my understanding is correct, this makes a mockery of the tax status of ISAs.

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Richard Admiraal

Nov 22, 2012 at 16:25

well, 'within reason as opposed to tax evasion'. i would have hoped that financial journalists such as Citywire would know the Jack & Jill difference between Tax evasion( illegal) and avoidance (legal) . it is understandable that HMRC & the Government have been happy to merge tax avoidance, tax evasion & even tax abuse into one & the same reprehensible activities but i would have hoped for better fron a financial journalist, don't you?

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Dividend Income investor.com

Nov 22, 2012 at 16:26

Hi Byran

Shares of companies paying dividends held in a stocks & shares ISA are paid post 10% withholding tax. Selling shares and securing a capital gain is tax free in an ISA. Re-investing your dividends in an ISA is tax free, etc, etc, while once you get to stage that you want to draw an income from your ISA that's also tax free.

What is there not to like?

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Bryan Jefferson

Nov 22, 2012 at 18:09

I don't really like the 10% withholding tax!

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In the Dark

Nov 22, 2012 at 22:34

@Richard Admiraal

Absolutely correct.

What is this nonsense about 'within reason' utter rubbish, as pointed out avoidance is legal; evasion is not, plain as the nose on your face.

Paying tax is not like paying to a charity, its is a legal requirement on profit, no morals or moralising involved. Evade your dues expect the full force of the law, arranging your affairs to reduce tax liability is a freedom we should cherish.

At the end of the day Government set the rules and we hold them to account through the ballot box.

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