Tax-efficient investing: ISAs and other tax-efficient ways to invest
While tax expenses can reduce your returns, there are ways to reduce your tax bill. Some of them include investing in tax-free accounts such as ISAs and SIPPs, and applying tax-loss harvesting for taxable accounts.
Why tax-efficient investing is important
Tax-efficient investing is important because it maximises returns while minimising costs. The goal of investing is long-term wealth creation. If tax-efficient strategies are not applied, a large portion of the value of your investment returns and income may be eaten away by tax expenses which can jeopardise the very goal of investing. Your post-tax returns are what’s important.
How are investments taxed in the UK?
The tax bill due on your investments will depend on your personal circumstances, such as your investment income and asset allocation in your portfolio. There are three taxes that may apply: income tax, dividend tax and capital gains tax.
Income tax applies when you earn interest on bonds, which for tax purposes is labelled as income. There is a personal allowance of £1000 which you can gain on bond yields tax-free for basic-rate taxpayers with annual income up to £50,000. When your annual income is above that threshold, your tax-free allowance drops to £500. For additional rate taxpayers, with annual income above £150,000, there is no allowance they can earn tax-free.
When you own shares in a company, you are likely to receive dividend payments and therefore are liable for dividend tax. In 2020/2021 tax year, the tax-free allowance you for dividends is £3000. The tax amounts to 7.5% for basic rate taxpayers, 32.5% for higher rate, and 38.1% for additional rate payers.
Capital gains tax
If you sell an asset that has appreciated in value, you earn a profit that’s known as a capital gain. The capital gain amounts to the buying price minus the selling price and may be liable for tax. In 2020/2021 tax year, the capital gain tax is 10% for the basic taxpayers, and 20% for higher and additional taxpayers. The rates are 18% and 28% respectively when realised on the sale of an additional home. There is currently an annual tax-free allowance of £12,300, and anything above that is liable for capital gains tax.
Capital gains tax can apply to shares, funds and bonds. Yet UK government bonds, known as gilts, enjoy a different treatment. While you still have to pay income tax on interest earned from gilts, they are exempt from capital gains tax. You can find a list of gilt-edged securities exempt from capital gains tax here.
Note that the capital tax rules may change in the near future. A recent report commissioned by Chancellor Rishi Sunak suggested that a hike in the rates and cut in exemptions could help pay off billions borrowed to support the economy amid the pandemic.
Stocks & Shares Individual Saving Accounts (ISAs)
Fortunately, there are ways to minimise tax expenses on investments in the UK. One of them is investing via Stocks and Shares Individual Saving Account (ISA), which is a tax-free account with an allowance of £20,000 contribution per tax year.
This means you would not pay any tax on capital gains as long as your annual investment is less than £20,000. ‘If you put money in a stocks and shares ISA, when you sell any investments to rebalance your portfolio, you won’t incur a taxable gain if you've made a profit,’ says IG’s portfolio manager Sam Dickens.
‘By making use of your annual ISA allowance, you get to keep more of your returns which helps to grow your wealth faster. Anyone who's thinking about saving or investing, should look to use an ISA account first.’
Stocks and Shares ISA can be opened with numerous providers, including IG. You can choose between actively managing your own investments or buying a ready-made investment portfolio based on your risk tolerance.
Any dividends that are received in an ISA account are free from dividend tax, and do not contribute to the £3000 allowance. This means you can have tax-free dividend income on your ISA account, plus use up your £3000 tax-free allowance in taxable investing accounts outside the ISA wrapper.
It’s important to note that ISA allowance applies to all ISA wrappers. Apart from Stocks and Shares, there are also Cash ISAs, Innovative Finance ISAs, Help to Buy ISAs, and Lifetime ISAs. Your contribution should not exceed £20,000 among all of the ISA accounts (if you happen to have more than one), otherwise your capital gains will be taxed.
You can only open one Stocks and Shares ISA per tax year, with an option to transfer cash or your investments between providers if you decide to switch.
How to invest in an ISA with IG
- Create your live account with IG in minutes
- Choose IG Smart Portfolios, which is managed for you, or share dealing, if you prefer a hands-on approach
- Add ISA to your account later
- Invest a lump sum and/or set up a regular instalment to fund your account
Self-invested personal pensions (SIPPs)
Self-invested personal pensions are like any other pension accounts, but you can actively manage where and how your pension money is invested. The government will give an extra boost for every contribution you make as a basic-rate tax relief. Once the money is in your SIPP, it can grow free from income and capital gains tax. You can either choose a ready-made portfolio or manage your own investments.
The tax relief from the government would depend on your annual income and income tax bracket. For the basic rate taxpayers, who pay 20% income tax, the tax relief is at 20%, which means if you contribute £10,000, the government pays extra £2000 into your SIPP. The tax relief payment in this case happens automatically.
If your annual income is higher, and you pay higher-rate tax of 40%, you can claim a further 20% through tax return of local tax office. The same principle applies to additional-rate taxpayers, who pay 45% income tax. They can claim a further 25% relief through tax return or local tax office.
IG’s portfolio manager Sam Dickens says that SIPPs are becoming more and more popular in the UK. ‘Historically the majority of companies offered what’s known as a defined benefit pension, where the number of years you worked at the company and your final salary determined what the company would pay you during retirement,’ he says. ‘These schemes put the investment responsibility on the company, any many found these to be too expensive to run and so many companies have closed these schemes. Instead, defined contribution schemes have taken their place which puts the saving and investing responsibility on the individual. With defined contribution schemes, the employee must decide what percentage of their salary they want to save away each month into their pension plan and how they want this to be invested.’
‘They can either choose to pay a proportion of their salary into the company’s scheme, or they can choose to invest it themselves in a SIPP.’ As Sam explains, to pay into a SIPP account, you should tell your HR the percentage you want to be paid from the payslip. ‘You can then pick and choose what to invest in. That could be shares, ETFs, or in a managed fund that is offered by the SIPP provider.’
There are some restrictions that come with SIPPs. Firstly, because it is a pension account, you can only access the money when you’re 55. This shifts to 57 in 2028.
Secondly, there is a limit to how much you can pay into your SIPP and earn a tax relief. This is called pensions annual allowance. In 2020/2021 your full contribution to SIPP shouldn’t exceed £40,000 per tax year. This includes contributions from your salary, your employer, or anyone else on your behalf.
There is also a lifetime allowance limit to your SIPP, which currently is at £1,073,100, but it’s set to rise in line with inflation. This means you cannot exceed this amount on your pension over your lifetime.
SIPP accounts can be suitable for those investors who are growing money towards retirement, as they offer numerous advantages such as income tax relief. Yet they wouldn’t work for investors with shorter time-horizons, such as those saving for a house deposit or education. You can open a SIPP account with numerous providers, including IG.
Tax-efficient strategies for taxable accounts
The general strategy for tax-efficient investing is to hold the least tax-efficient assets in tax-free accounts, and vice versa. For example, high-dividend stocks are better off in tax-free accounts, such as ISAs or SIPPs. You should always first use up your tax-free ISA allowance, and only then look into opening a taxable account.
Tax loss harvesting
Another strategy you could use to minimise your expenses on taxable accounts is tax loss harvesting. This strategy involves selling any losing investments on your account at the end of the tax year. In this way, you can claim the loss against capital gains, and pay less tax overall.
The strategy may sound counter-intuitive, as you may want to hold on to the losing investment until its price rebounds. Yet tax-harvesting is a two-step process. After selling the losing investment, you can buy it again at the discounted price. Note that when practising tax-harvesting you cannot sell and buy the exact same security. There is a 30-day rule which means you cannot buy the same share within 30 days or you won't be able to use the taxable loss. Instead, you could buy an investment in the same sector.
For example, imagine you have just sold an airline stock that’s been underperforming recently to lessen the overall capital tax expenses on your account. Rather than investing in the same stock, you’ll have to either choose a different airline company, or invest in a sector ETF, such as iShares Transportation Average or US Global Jets.
IG’s portfolio manager Sam Dickens says: ‘It's not directly the same exposure, different companies have different risks. But it creates a taxable loss which the investor can use to offset any taxable gains from elsewhere in their portfolio. Capital losses can be carried forward indefinitely. It basically becomes an allowance that can offset any future tax gains.’
Tax-efficient investing: the bottom line
When starting off your investing journey, you should first consider investing in an ISA or a SIPP for retirement. That way you will avoid capital gains taxes, and taxes on dividends. If you have exceeded your ISA or SIPP allowance, you could consider taxable accounts. Yet make sure to use them wisely, keeping the least tax-efficient investments, such as high-dividend stocks, in your tax-free accounts. You could also use tax-loss harvesting as a strategy to offset any capital gains.
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