Introduction
Financial planners often talk about tax ‘wrappers’. By this term, they mean the legal structure used to hold investments, which will always influence how returns are taxed.
Most people are familiar with ISAs. An ISA is a tax wrapper that allows investments and deposits to be held up to certain amounts that the Government specifies from time and to get returns almost completely tax free.
Some tax wrappers have very specific rules because they reflect government policy and in effect have incentives (and restrictions) built in to encourage certain behaviors. A personal pension is an obvious example, where the valuable tax reliefs given when you put money in are lost and in fact there may even be severe penalties if you try to access your money before you are aged 55 because you are supposed to be saving for your retirement.
Other savings and investment products can have quite obscure tax treatment because of past history and how they came to be created.
Life assurance bonds are a good example. When you make money from investments in such a plan you get taxed on what are called Chargeable Gains, which sounds like a capital tax, but in fact this in an income tax calculation using some quite odd rules that can have unpredictable consequences. Quite recently special provisions were made to allow the tax authorities to unravel disastrous accidents resulting in large tax bills for people who had no idea what the rules were and who actually have not made any money!
How to choose?
Although the UK tax system has a great deal of complexity in its details, at a very high level the average investor only needs to think about a very small number of issues:
- Am I using all the tax reliefs that are available to me?
- If I am going to pay tax, is it better to pay tax on capital gains or on income? This is the question most often not dealt with properly.
- Should I pay tax as soon as I get my gains (ie in the same tax year), or defer paying it until later, if that could be arranged (it usually can).
- Can I leave the bulk of the taxes to be paid after I have died?
A good financial adviser may earn their fees many times over by dealing with these issues properly. They will not be advising fancy tax avoidance schemes or illegal trickery.
A suitably qualified adviser will have taken examinations after studying the UK tax system for individuals and will also undertake continuous studies to stay up to date. There is a whole industry devoted to broadcasting the implication of changes in the tax system and working out what they mean in all possible scenarios!
NotHarry does not offer personal financial advice, but here are some general pointers.
- It is often better to have investment returns in the form of capital gains as very few people use their annual tax-exempt allowance that is well into five figures. As the allowance is for gains, not the amount sold (ie it is the profit element that is assessed against the allowance), sales of investments amounting to tens of thousands of pounds can happen every year with no tax to pay.
- If your portfolio includes a pension fund and you have several other options for getting income, it is usually best to leave the pension alone as it is a potential tax-free inheritance in most cases and your heirs may get tax free returns from the pension fund that you can’t get yourself!
- Direct investments in property, especially residential property, are taxed more harshly than any other form of mainstream investment, so bear that in mind if you fancy being a landlord.
- If you have the option to take a large income from your investment portfolio but don’t need it all, perhaps thinking you will want it later to pay for long term care (eg nursing home fees), it can be better to take some income earlier and use all your basic rate tax allowance, reducing the possibility of paying a large amount of higher rate tax later. The income that you don’t need can be re-invested using ISA allowances, or in other ways that will eliminate extra tax later.
- Giving to charity is tax efficient as well as being a nice thing to do! This even works after you have died!
- Don’t let the “tax tail wag the dog”. If you make your arrangements overly complicated just to avoid tax, you may actually lose out on investment opportunities. A 100% return less 40% tax is a lot better than a 25% tax free return!
- Take with a pinch of salt a proposal from any adviser who stresses the suitability of an investment only or mainly on the basis of tax saving. A good adviser recommends an investment strategy first and then explains which tax wrappers will be most effective as a later stage. Make sure that tax savings would really be savings for you – not just hypothetical. If you were not going to pay tax on something anyway, having a tax free (but highly charged) investment plan is not helpful.
- Bear in mind that where the government offers really generous tax incentives for high risk, possibly entrepreneurial schemes, you can expect to lose all your money if things go wrong.
- Be careful about what advisers tell you about investment schemes that have big tax reliefs and apparently very little risk. Some pretty famous people have been embarrassed to get in trouble with the tax authorities when such schemes were successfully challenged by the tax authorities in Court and they had to give back the tax relief.