How to Avoid Income Tax on Your Investments
Investment Income Tax Strategies
SOME investments are much more tax efficient than others. Some can be squirrelled away in tax shelters like ISAs and SIPPs, or maybe even a company.
Other investments produce more capital gains than income. From a tax saving perspective, capital gains are much better than income: The tax rates are lower and there are lots of reliefs that can help you completely avoid capital gains tax.
In this article, we will take a look at how you can reduce or avoid paying tax on the income you receive from your investments, including:
- Stock market dividends
- Rental income
Unless sheltered from tax, investments that generate interest income should generally be avoided wherever possible, especially if you are a higher-rate taxpayer.
With inflation running at around 3.5%, someone who pays 40% tax would need to earn 5.8% before tax just to remain standing still and maintain the real value of their capital.
Of course, most investments that pay interest do not deliver anywhere near 5.8%, which means most people will see their savings eroded by inflation.
The obvious way to make sure your interest is tax free is to use ISAs. The cash ISA limit is £5,640 for the current 2012/13 tax year. You can also invest in corporate bonds and other bonds through a ‘stocks & shares’ ISA. The limit for the current tax year is £11,280.
Other tax-free investments include index-linked savings certificates (when they’re available) and offset mortgages (instead of earning interest, your savings are used to reduce the interest on your mortgage). Even paying off personal debts is effectively a way to earn tax-free interest.
Although you should avoid taxable interest wherever possible there may be times in life when you cannot avoid it:
- If you sell your house and have a large cash lump sum
- If you lend money to a friend or family member
- If you pay yourself a big dividend
- If you lend money to your company
The good news for company directors who receive taxable interest is that they may end up paying just 10% income tax (see article earlier in this issue).
Stock Market Dividends
The big difference between dividends from your own company and dividends from stock market companies is that stock market dividends can be completely sheltered from income tax by investing via an ISA or SIPP.
As a result, most people should be able to shelter ALL of their stock market dividends from tax.
In practice, however, many stock market investors do in fact end up with a mixture of shares held inside and outside the tax protection of ISAs and SIPPs.
A good example is a cash-rich investor who wants to invest more than the £11,280 ISA limit but doesn’t want to invest via a SIPP.
If the investor is a higher-rate taxpayer (income over £42,475 in 2012/13), any dividends received on shares held outside an ISA will be subject to income tax at an effective rate of 25%. If the investor has income over £150,000, the effective rate increases to 36.1%.
These investors could consider adopting the following strategy:
- Hold high-income shares inside an ISA (to protect the dividends from income tax), and
- Hold growth shares that produce capital gains outside an ISA (because up to £10,600 of capital gains will be tax free anyway thanks to the annual CGT exemption).
This strategy will not always produce the biggest tax savings, however. If you bought Apple shares back in 2003 – before their almost 10,000% rise – you would be kicking yourself if you didn’t stick them in an ISA!
Apart from cash-rich individuals who invest more than the ISA allowance, your stock market dividends may also fall into the tax net if you receive them from:
- AIM shares
- Share clubs
AIM shares (generally smaller public companies) are popular with many stock market investors and are often tipped in magazines like Investors Chronicle.
Most people invest in these companies for capital growth but some do pay significant dividends.
AIM shares can always be held in your SIPP but generally cannot be held in an ISA (because AIM is not a “recognised” stock exchange).
However, a few AIM companies can be put in an ISA because they also have another listing on a recognised stock exchange in, say, Australia, Canada or Hong Kong.
In summary, dividends from some AIM companies can be sheltered from income tax in an ISA. Dividends from all AIM companies can be sheltered from tax in a SIPP.
Share Clubs & Privatisations/Demutualisations
If you belong to a share investment club, your share of any dividends will be subject to income tax if you are a higher-rate taxpayer.
Most individuals will not, however, receive more than a couple of hundred pounds of dividends from a share investment club.
I know several individuals who received shares in companies that were privatised or demutualised (for example, Standard Life’s 2006 demutualisation) and the investments are not held in a tax wrapper. As a result, income tax is payable on any dividends, unless the investor is a basic-rate taxpayer.
Income Tax on Dividends – How Big a Problem?
Unlike dividends from your own company, you cannot control the amount of income you receive from stock market companies.
So if you have significant dividends from stock market companies, and the shares are not sheltered inside an ISA or SIPP, you may want to reduce the dividends you extract from your own company to avoid going over one of the key income tax thresholds.
However, my gut feeling is that stock market dividends do not cause tax problems for most individuals. The main exception is wealthy investors who hold a significant portfolio of shares outside a tax wrapper.
Even if you own, say, £100,000 worth of shares outside an ISA or SIPP you will probably receive no more than £4,000 per year in dividends, producing an income tax bill of £1,000 for a higher-rate taxpayer.
Rental profits from residential property can NOT be sheltered from income tax in an ISA or SIPP.
Your rental profits will generally be taxed at 20%, 40% or 50%, depending on how much other income you have.
This is an important point to remember if you are weighing up the pros and cons of investing in residential property, shares or other investments.
A higher-rate taxpayer who receives £5,000 of dividends from shares held in an ISA will pay no income tax. If the same individual enjoys £5,000 of rental profits from buy-to-let property, a £2,000 income tax bill will be payable.
In many parts of the country, the only returns currently being enjoyed by buy-to-let investors are rental profits: capital growth can be hard to come by these days!
Not all buy-to-let investors have significant rental profits, however: particularly those with large borrowings. Interest charges still eat up a lot of rental income. Interest rates on some buy-to-let mortgages have been creeping up and the arrangement fees often run to thousands of pounds.
Even those with rental profits may not be paying any income tax because their profits are offset against rental losses brought forward from previous years.
The bottom line: If you are making rental profits and do not have losses to offset, you will pay income tax that cannot be avoided by investing via an ISA or SIPP. In the absence of capital growth, you will be left with one of the most heavily taxed investments around. The tax paid could be anything from 20% to perhaps 60% this year, rising to over 60% next year if your rental profits cause your child benefit to be withdrawn.
Avoiding Income Tax on Rental Income
There are two main strategies you can follow to avoid paying income tax on your rental profits. One is simple, the other a bit more complicated.
- Make pension contributions
- Invest via a company
We’ve covered pension contributions in recent issues. The basic idea is this: If you stick your rental profits in a pension, you can completely avoid paying income tax on them. Note, however, that to make pension contributions of more than £2,880 a year (net), you must have earnings (typically a salary or profits from self employment).
If you use a company to invest in property, you will probably pay just 20% tax on your rental profits. You can use either an existing trading company or a separate standalone company (each of these two routes has pros and cons).
Unlike residential property, commercial property can be sheltered from tax in a SIPP. Many business owners use this facility to shelter their business premises from income tax and capital gains tax.
Certain commercial property investments can also be sheltered inside an ISA, namely commercial property unit trusts and real estate investment trusts (REITs).
Some have historic yields of around 4% which, being tax free if held in an ISA, is equivalent to earning 6.67% from a regular bricks and mortar property. Remember that yield is net of all costs.
Commercial property funds also have other benefits: a big spread of properties and access to possibly high quality tenants and properties that a small commercial property investor may not be able to afford.
Capital Gains Tax & Income Tax
Capital gains tax and income tax interact with each other. Why? Basic-rate taxpayers pay 18% capital gains tax; higher-rate taxpayers pay 28%.
The basic-rate band for the current 2012/13 tax year is £34,370. This means everyone can have up to £34,370 of capital gains (over and above the annual CGT exemption) taxed at 18% instead of 28%.
Total potential tax saving: £3,437.
To have your capital gains taxed at 18% you need to ensure that your basic-rate band is not used up by taxable income. Of course, not everyone can reduce their taxable income in years in which large capital gains are received. Those who can control their income from year to year include company directors and retirees who use pension drawdown arrangements.