How Tax Affects Wealth Accumulation For UK Investors
This article is part 1 of a series entitled Tax Efficient Wealth Accumulation For UK Investors. The series will explain the workings of particular aspects of the UK tax system which affect typical private investors and offer guidance to help mitigate the effects of taxation on your investment portfolio. The series will cover all well-known techniques for tax minimisation but will intentionally avoid 'exotic' techniques and 'tax avoidance schemes'. Please note that none of the material contained in this series should be interpreted as 'advice'. When planning your own affairs, always do your own research using official documentation and, if in doubt, please take appropriate professional advice.
In this article, you will learn about which parts of the UK tax system you need to pay attention to in order to minimise the impact of taxation upon the growth of your investment portfolio.
What is tax?
The government of the United Kingdom spends an amount of money (annually) equivalent to around 40% of the country's Gross Domestic Product. This government spending covers a wide variety of things from maintaining a military (in order to protect the country) to the welfare state which is intended to provide for citizens when they are unable to provide for themselves.
The majority of government spending is funded by various types of taxes levied upon UK residents and companies. Taxes, as used in the context of this article, are statutory payments (i.e. you don't have a choice about whether or not you pay them). Taxes are usually collected by a government body called Her Majesty's Revenue and Customs (HMRC).
In many cases, taxes can be legally avoided and thus money which you would usually pay in tax can be diverted to your investment portfolio. Therefore, when it comes to building up investment assets, reducing the impact of taxation is often one of the most effective ways to maximise your rate of wealth accumulation and achieve your goals more quickly.
In short, if you want to accumulate wealth faster in order to retire earlier, you'll need to formulate a strategy to interact with the tax system as efficiently as possible.
Which taxes should I care about?
In order to explain how to accumulate wealth tax efficiently, it will be helpful to think briefly about some of the ways that the UK government currently collects tax.
It's worth noting to begin with that the UK tax system is extremely complex. Taxes are levied, for example, on incomes from jobs and purchases in shops, as usage fees for certain services and as duties on imports. As such, it would be overwhelming to attempt to understand every single detail of the system.
However, the following principles will help us to focus upon the particular taxes which have the most pernicious effects on our wealth accumulation as investors:
You need to maximise the amount of your income (whether from your job or a business) which goes to you or into your portfolio (rather than to HMRC).
You need to prevent, as far as possible, any investment gains within your portfolio from being taxed.
You need to avoid inadvertently paying excessive transaction taxes by over-trading
There are some more advanced concepts which will be addressed later in the series, but learning how to apply these three principles alone has the potential to make you wealthy much more quickly than if you blindly bought a few shares out of your salary each month without any regard for tax efficiency.
If you intend to leave a legacy after your death, you may also benefit from learning about how inheritances are taxed in the UK.
Tax on your income
The vast majority of income earners in the UK are employees (we'll consider these issues from the point of view of business owners later in the series). If you're an employee, the taxes levied directly on your income are
National Insurance (NI)
The income tax and NI paid by an employee in a given tax year is determined by the amount of income earned by the employee in that tax year. As the UK has a so-called 'progressive' tax system, the proportion of your income you will pay as tax increases with your income.
As a UK taxpayer, you also benefit from a so-called 'tax free allowance' (currently £12,500 per annum) of income you are permitted to earn without paying any income tax although NI is charged on earnings much lower than this level.
How does this translate to the actual amounts of tax paid by UK employees? Here are some examples:
A person who earns £10,000 per annum will not pay any income tax at all
A person who earns £40,000 per year will pay £5,498.20 per year in income tax (around 13.8% of total income)
A person who earns £100,000 per year will pay £27,496.40 per year in income tax (around 27.5% of total income)
But income tax is only half the story. How about NI?
Well, calculating the amount of NI payable by a UK employee is a little more complicated than performing the income tax calculations above. The final figure can be affected by things like how many jobs the employee has, when each job was started and whether or not the employee is also a director of the employing company.
However, assuming that our employee is employed constantly by a single employer, we can add to the example above to account for the effect of NI on the amount of income the employee actually gets to keep:
A person who earns £10,000 per annum will not pay any income tax at all, but will pay £164.16 in NI, leaving 'take home' pay of £9,835.84 and an effective tax rate of approximately 1.64%
A person who earns £40,000 per annum will pay £5,498.20 per year in income tax plus £3,764.16 in NI, leaving 'take home' pay of £30,737.64 and an effective tax rate of approximately 23.2%
A person who earns £100,000 per annum will pay £27,496.40 per year in income tax plus £5,964.16 in NI, leaving 'take home' pay of £66,539.44 and an effective tax rate of approximately 33.5%
As you can see, the amounts involved are quite considerable (moreso as income increases). It's definitely worth trying to divert some of that money away from HMRC and towards your investment portfolio.
How can I avoid it?
The two basic strategies for reducing the amount of income-related tax you pay in order to increase the amount which can be contributed to your investment portfolio can be summarised as
Arrange to be paid less 'cash' by your employer. Money you would usually receive in salary can then be received as direct contributions to your investment portfolio (usually as contributions to a pension of some sort). This strategy can potentially be used to reduce the amounts of income tax AND NI paid.
After receiving your salary, invest funds in such a way that you receive a 'tax credit' or 'tax relief' on the investment, thus reclaiming tax you have already paid. This strategy can generally be used to reduce the amount of income tax paid but NOT NI.
Specific techniques for implementing these strategies will be given in later articles in this series.
Tax on your investment gains
Investment gains can generally be split into two categories:
Income (for example interest on cash savings or dividends paid out on shares held)
Capital Gains (increases in the market value of an investment)
Income from investments is usually subject to Income Tax. However there are various exemptions, allowances and rates in effect so a full treatment of how much income tax you are likely to pay on income from investments won't be given here. In general, investment income is taxed at rates from 0% (all income exempt from taxation) to 38.1% (dividend tax rate for an 'additional rate' taxpayer).
It is important to note that investment income interacts with 'earned' income when it comes to determining your income tax liability. For example, a 'higher rate' Income Tax payer will pay more tax on £10,000 of dividends than a 'basic rate' taxpayer who held the same investments would.
Capital Gains Tax (CGT)
Capital gains are only taxed when you sell an investment (assuming there has been an increase in value since you bought it). Although capital gains are taxed separately from income, your total income determines the rate at which you will pay tax on any capital gains. For example, if you are a 'basic rate' taxpayer you will pay 10% on any taxable gain you make when selling shares, whereas a 'higher rate' taxpayer would have to pay CGT at a rate of 20% on the same gain.
How can I avoid it?
The four basic strategies for reducing the amount of tax you pay on your investment gains are:
Hold investments in tax-efficient wrappers such as investment ISAs and pensions where possible so that all gains are tax-free. Look out for opportunities to move 'unwrapped' investments inside tax-efficient wrappers where possible. This strategy can be effective in reducing both Income Tax and CGT.
Where investments are held outside tax-efficient wrappers, be aware of personal tax exemption allowances for income tax, capital gains tax and tax on savings interest. Be mindful of when investments are bought and sold with relation to the tax year and consider timing transactions to minimise the amount of tax paid. This strategy can be used to minimise CGT.
Look out for opportunities to 'harvest' capital losses in order to offset them against any taxable gains you might have at the time . This strategy can be used to minimise CGT.
Distribute investment assets between 2 or more people (e.g, a husband and wife) in order to take advantage of the personal tax allowances of all parties. This strategy can be effective in reducing both Income Tax and CGT.
Tax on investment transactions
Most investment transactions in the UK are subject to Stamp Duty Reserve Tax (SDRT), more commonly known as Stamp Duty .
Exceptions to this rule are investments in
- UK Gilts (government bonds)
- Two types of 'collective investment': Open Ended Investment Companies (OEICs) and Unit Trusts
Note however that the fund managers who run OEICs and Unit Trusts are charged stamp duty and hence it will generally be passed on to the investor (you!) in the form of various management fees.
What's the damage?
The rate of stamp duty is 0.5% of the amount of the investment transaction. For example, if you bought shares valued at £1000, you would pay £50 in stamp duty.
How can I avoid it?
Let's deal with Gilts first. Although Gilts may form part of a sensible, balanced portfolio, investing in Gilts only in order to avoid stamp duty would probably not be a good strategy and is a good example of the 'tax tail wagging the investment dog'.
As for other investment types, unfortunately, even transactions within tax-efficient wrappers such as ISAs attract stamp duty so there's nothing you can do about paying it on the transactions you do conduct.
However, it is possible to minimise the amount of stamp duty you pay overall by keeping the total amount that you transact to a minimum.
For example, let's say you buy £1,000 of shares and then subsequently decide that you want to be invested in something different. You then sell the original holding to buy shares in the new company. In this case you will have paid a similar amount of stamp duty twice: once when you bought the original holding and then again when you bought the second holding.
Note that this is not advice to never sell a holding and then buy something different. Rather it is a warning about the potential tax costs caused by buying and selling frequently.
The following example illustrates the difference between Amanda, a savvy, tax-efficient private investor and Belinda who 'dabbles' in buying shares from money saved from her salary.
Amanda is an employee with a salary of £60,000 per year. This gives her monthly 'take home' pay of £3,611.62.
She arranges with her employer to instead be paid £40,000 per year in salary and have £20,000 per year paid into her Self Invested Personal Pension account. She pays no tax or NI on the money paid into her pension. Her new monthly net pay is £2,561.47 (£1,050.15 less than it was before the new arrangement).
It therefore 'costs' Amanda 12 x £1,050.15 = £12,601.80 in money she would otherwise have had in her bank account to get £20,000 into her pension.
Amanda buys shares inside her pension which, over the course of the next 20 years, gain approximately 3% per year in value and pay a dividend of approximately 4% per year giving a total return of 7% per year.
Amanda 'buys and holds' the shares (i.e. she never sells them in order to buy something different).
As the investment gains are 'sheltered' and thus attract no tax, after 20 years of this arrangement, Amanda's pension account is worth around £875,000
Belinda also has a salary of £60,000 per year, so she starts with monthly take home pay of £3,611,62.
She also invests each month but just takes the money from her net pay. She invests enough to reduce her take home pay to the same figure as Amanda's (after her new salary sacrifice arrangement). Belinda is therefore investing £12,601.80 per year.
Belinda buys her investments in a taxable investment account. As she's a higher-rate tax payer, she pays CGT at a rate of 20% and Income Tax on dividends at a rate of 32.5%.
Belinda has a habit of trying to 'lock in' gains on shares that have appreciated in value quickly and then buy shares that 'look cheap'. For every pound she invests, she ends up paying stamp duty 4 times (i.e. 4 x 0.5% = 2%) and also sometimes triggers a CGT charge due to the fact she 'trades' so much.
The combined effect of all 3 types of tax is to reduce Belinda's total investment returns from 7% per annum (like Amanda's) to 6% per annum.
Over the next 20 years, Belinda's investment account grows to approximately £490,000.
Clearly Amanda's approach to investing tax efficiently has resulted in a much higher portfolio value after 20 years (almost 80% higher) despite the fact that both people have had to give up an identical amount of money in the present in order to invest it in their portfolio.
It must be noted that there are many other factors to consider here (for example, how the investment gains are likely to be taxed when Amanda and Belinda want to start living off their portfolios).
However, the principle is very clear: ignoring the effects of tax on the rate of wealth accumulation as an investor is not advisable. Tax can have a significant impact upon the rate of wealth growth and so forming a good tax minimisation strategy is a crucial part of a financial plan for any private investor.
If you'd like to learn more about specific techniques to help you to accumulate wealth tax efficiently, watch out for the subsequent articles in this series.
Enjoyed reading this?
Get notified about the latest Rebo features, blog posts and updates before anyone else.