View the article online at http://citywire.co.uk/money/article/a636139
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.
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.
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.
News sponsored by:
Making the most out of Europe's potential means seeing things differently. Learn more about how BlackRock's focused approach to investing in Europe helps investors unlock the continent's vast potential.
In this guide to investment trusts, produced in association with Aberdeen Asset Management, we spoke to many of the leading experts in the field to find out more.
More about this:
More from us
What others are saying
Tools from Citywire Money
From the Forums
Weekly email from The Lolly
Get simple, easy ways to make more from your money. Just enter your email address below
An error occured while subscribing your email. Please try again later.
Thank you for registering for your weekly newsletter from The Lolly.
Keep an eye out for us in your inbox, and please add email@example.com to your safe senders list so we don't get junked.