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An example of defusing capital gains

Image of a wires being cut to defuse.

The end of the tax year is April 5th. For many people, the weeks beforehand are a rush to put money into an ISA before the year’s annual ISA allowance is lost – despite them having already had 11 months to open or add to an ISA to earn interest, dividends, and capital gains tax-free, forever.

People, eh?

But what about those of us who do dutifully max out our ISAs at the start of every tax year – and who are lucky enough to still have cash leftover, even after pension contributions?

Or those who inherit a fat wodge and haven’t been able to ISA-size it all yet?

Or those of us (*whistles* *looks at feet*) who many years ago were dumb enough to invest outside of ISAs for no good reason?1

After a few years and a strong market, such investments made outside of tax wrappers can be carrying significant capital gains.

Keep on top of growing capital gains

High-rollers / reformed muppets with this high-class problem should be sure to use their annual capital gains tax allowance2 every year.

In the 2017/2018 tax year, you can realise £11,300 in capital gains tax-free, across all your CGT chargeable investments.

Remember, CGT is only liable when you realize the capital gain – that is, when you sell (in most cases) sufficient assets to generate more than £11,300 worth of gains (aka profits).

Until you sell, you can let capital gains roll up unmolested by tax. Deferring gains like this is better for your finances than paying taxes every year. But best of all is to pay no tax.

The trick then is to sell just enough assets to use your CGT allowance to trim back the long-term tax liabilities you’re building up, but not enough to trigger a tax charge.

You may also want to realize some capital losses to enhance the operation.

I call this process defusing capital gains.

Remember, taxes can significantly reduce your returns over the long-term.

Yet taxes are also a bit like high fees, in that being vigilant over your lifetime of investing can significantly lessen their impact.

Let’s consider an example to see.

Brief rant on Tax Justice Warriors

Before we begin, a quick interlude – necessary because some people always moan whenever I talk about mitigating taxes on investments.

We’re not fat cats around here. We’re ordinary people trying to achieve financial freedom on our own terms in a tough world.

I don’t want to hear (at least not on this post) how we should be handing the State a huge chunk of the gains we make by risking our own money out of some moral responsibility that most of the moaners would not feel if they were in our shoes.

I know how hard it is to compound stock market returns on an unspectacular middle-class income, because I’ve been doing it for the past 20 years.

It’s at least as hard as sitting in your million pound house in a London suburb that you bought in the late 1990s with a 95% mortgage – a house that has quintupled over two decades, multiplying your initial deposit 80-fold, entirely tax-free to you – and looking up from the Guardian to complain about share ‘speculators’.

Tax mitigation is legal and sensible. People can use the money they save on taxes however they choose. We admire those who give it to good causes or otherwise invest it in noble pursuits. But simply handing it over to the State because you weren’t paying attention hardly seems like intentional living.

If I roughly tot up the taxes I’ve paid over the past five or six years, I find that despite my best efforts I’m still paying plenty (not least thanks to a Stamp Duty Land Tax wealth amputation) and doing my bit.

There’s a time and a place to discuss the appropriate level of taxation, but I’m decreeing this isn’t it.

(I’m ready to delete rogue Citizen Smiths to keep the comments below on-topic.)

Deter-rant over. Thank you!

An example of defusing capital gains

I’ve written before how you can defuse gains by using your CGT allowance to curb the growth of your CGT liability over the years. I’d suggest you read that article before continuing with this one.

A good use for money raised from defusing, by the way, is to fund your next ISA! (Reminder: You can do so every year from April 6th.)

Let’s work through an example to see how you go about defusing a gain.

It’s not that bad! Defusing is usually not as complicated as this example is about to sound, because your broker, software, or record keeping spreadsheet can help you keep track of the ongoing gains on each of your holdings. I’m just showing the underlying calculations here for clarity. Make sure you keep great records if you invest outside of tax shelters! The paperwork can be painful, but it is necessary.

A worked example of CGT defusing

Let’s say you invest £100,000 in Monevator Ltd – a small cap share that pays no dividend, but whose share price proceeds to grow at a very rapid 30% a year rate for three years.

After this period you decide to sell up and use the money to buy an ice cream van and become a self-made mogul like Duncan Bannatyne.

Is it a good idea to defuse or not to defuse along the way?

Here are two scenarios to help us answer that question (rounding numbers throughout for simplicity).

Scenario 1: You don’t sell any shares for three years

What if you don’t defuse? In this case your initial £100,000 of shares in Monevator Ltd compounds at 30% a year for three years.

At the end of the third year / beginning of the fourth year your shareholding is worth £219,700 and you sell the lot. You have thus realized a taxable gain of £119,700. (That is: £219,700 minus £100,000).

Assuming the annual capital gains tax free allowance is £11,300 in four years time – and assuming this is the only chargeable asset you sell that year, so there are no other gains or losses to complicate things – you will be taxed on a gain of £108,4003.

The tax rate depends on your income tax bracket. You are taxed on capital gains on shares at a basic 10% rate, with higher rate tax payers paying 20% on their gains.

From my previous article, you’ll know the taxable capital gain itself is added to your taxable income to determine your income tax bracket.

The basic income tax band is currently £33,500, so clearly most or all of the £108,400 in gains is going be taxed at a rate of 20% in this example.

Let’s presume you’re already a higher-rate tax payer from your job – a fair assumption for most people who pay capital gains taxes on shares.

At a tax rate of 20%, then, that £108,400 taxable gain will result in a CGT tax bill of £21,680.

You pay your tax and are left with £198,0204 for your next venture.

Remember: To keep things simple I’m presuming you don’t have any capital losses that you can offset against this gain to reduce your liability.

Scenario 2: You defuse your gains over the years

What if instead you’d sold enough assets to use up your capital gains tax allowance every year?

In the first year the holding in Monevator Ltd grows 30% to £130,000 for a capital gain of £30,000.

Remember: It’s not a taxable gain until you actually sell the shares.

You’re allowed to make £11,300 a year in taxable capital gains before capital gains tax becomes liable.

So what we need to do is to sell enough shares to realize a £11,300 taxable gain, which we are allowed to take tax-free. (i.e. We CANNOT just sell £11,300 worth of shares).

First we need to work out what value of shares produced a £11,300 gain.

A quick bit of algebra:

x*1.3 = x+11300
1.3x-x=11300
0.3x=11300
x=37,667

So £37,667 growing at 30% results in an £11,300 gain, which we can take tax-free under our CGT allowance.

We need to sell £37,667+£11,300 = £48,967 of the £130,000 shareholding.

Note: You could reinvest this money into the same asset after 30 days have passed, according to the Capital Gains Tax rules, or into a different asset altogether.

In the second year, we start with an ongoing holding of £81,033.5 Again it grows by 30%, so we end the year with £105,343.

But remember, this ongoing shareholding had already grown 30% in the previous year!

So the maths is:

x*1.3*1.3 = x+11,300
1.69x-x=11,300
0.69x=11,300
x=16,377

So £16,377 has grown by 30% per year for two years to produce the £11,300 tax-free gain we want to use up our allowance.

We need to sell £16,377+£11,300=£27,677 of the £105,343 shareholding.

In the third / final year, we are down to a shareholding of £77,666, which grows by 30% once more to £100,966

x*1.3*1.3*1.3 = x+11,300
2.197x-x=11,300
1.197x=11,300
x=9,440

Over the three years, £9,440 has grown by 30% every year to produce an £11,300 gain. We must sell £9,440+£11,300 to realize this gain and use up our CGT tax-free allowance.

i.e. We need to sell £20,740.

This leaves us carrying a holding of £80,226.

In total over the three years we have sold £97,384 worth of shares, and realized £33,900 in capital gains entirely free of tax.

Let’s once again assume we still need all our money as cash for the ice cream van business at the start of year four, as in scenario one.

The fourth year is a new year, so we’ve a new £11,300 capital gains allowance to use.

But now we are going to pay some capital gains tax.

The £80,226 holding we are still carrying was originally worth £36,516, before it grew at 30% every year for three years.6

We pay tax on the gain only, which is:

£80,226-36,516 = £43,710

We have that personal allowance of £11,300:

£43,710-11,300 = £32,410

The final (and only) tax bill on selling up the remaining £80,226 stake is therefore:

(£32,410) x 0.2

= £6,482

Compared to scenario one, we’ve saved £15,198 in taxes.

After tax we have £73,744 left from our final share sale, plus the £97,384 we sold along the way to give us total proceeds of £171,128.

(Before you start to type something in response to that, please read on!)

Is it worth defusing capital gains?

I can think of plenty of things I’d rather do with £15,198 than give it to the Government, so I vote ‘yes’, defusing is worthwhile.

Your mileage may vary.

But note that this is a very over-simplified example.

A 30% a year gain for three years in a row is very unlikely, even with winning shares – in reality even with the best performing companies or funds you’ll get up years and down years, likely spread over many more than three years.

You’ll probably also have more than one investment, so you’ll need to consider your gains and losses across the portfolio.7

I also completely ignored the issue of what you’d do with the money you liberate if you do defuse your gains along the way.

In fact, I’ve ignored overall returns altogether! I just wanted to show the tax consequences.

The eagle-eyed have probably already spotted that Scenario 1 leaves you with more money than Scenario 2, despite the higher tax bill.

This is a consequence of the money being left idle in Scenario 2 after annual defusing. In the first ‘pay it all out at the end’ strategy, all the money grows at 30% for three years – clearly a great investment.

In practice, cash released from defusing capital gains can of course be reinvested (though I wouldn’t bank on 30% returns each time if I were you!)

  • £20,000 a year of the proceeds could go into an ISA and be free of future CGT on gains. You could rebuy the same asset there (or in a SIPP, for that matter).
  • You could also sit on the money for more than 30 days before re-buying the same asset outside of an ISA.
  • Or you could immediately buy something different outside of an ISA, or just keep it in a cash savings account.

In Scenario two, the cash released could have been reinvested at the end of years one and two for (hopefully) further gains.

And just to complete the circle, if we do assume the proceeds of defusing in my example were reinvested at the same (crazy high for illustration’s sake) rate then you’d have a total final pot of £213,2188, which is of course £15,198 more than you were left with in Scenario 1. (i.e. Exactly what we saved in taxes!)

You might also argue I didn’t give the non-defusing strategy the very best shake. We could have sold one chunk on the last day of the third tax year, and then the rest on the first day of fourth year, to use up two lots of CGT allowance. This would have slightly reduced the tax bill.

But selling over two years like that is defusing gains, too! So the example is good enough I think.

As I say, it is just a fanciful illustration anyway. (I choose an unrealistically annual return number because the alternative was to illustrate a much more realistic 30-year defusing schedule – fine in a spreadsheet but even more boring to work through!)

The bottom line is taxes will reduce your returns, but there are things you can do to reduce how much you pay, from investing in tax shelters like ISAs and SIPPs, to exploiting your personal CGT allowance and offsetting with capital losses, as well as taking into account any spouse’s tax situation.

If you’re lucky enough to have capital gains, use all these techniques in combination to keep as much the gains as you can.

  1. Note: Laziness, trying to save a few pennies in charges, thinking “taxes won’t affect me” because you only look at one or two years expected returns, and not doing your research on the impact of taxes on investing returns are NOT good reasons. []
  2. Also known as your ‘Annual Exempt Amount’, if only by HMRC. []
  3. £119,700-£11,300. []
  4. £219,700 – £21,680. []
  5. £130,000-£48,967. []
  6. x*2.197=£80,226, so x=£36,516. []
  7. Are you a millionaire investing outside of tax wrappers? Then this is one reason not to use an all-in-one-fund, if you want to be as tax efficient as possible. If you buy and manage a portfolio of separate funds for yourself, you may be able to defuse the growing CGT liability by using the likely losses, as well as your personal allowance every year. []
  8. £82,754+£35,980+£20,740+£73,744. []

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{ 68 comments… add one }
  • 51 YoungFiGuy March 29, 2018, 6:07 pm

    @ The Rhino – The Wealthy Accountant does do rather well for himself. Alas, I’m not a tax accountant, so always take what I say with a large grain of scepticism. Quite frankly, tax rules in this country (and most other countries) are mindbogglingly complicated – and there are much more fun things to do!

  • 52 YoungFiGuy March 29, 2018, 6:13 pm

    @John Nicholas and TI – Sorry for the spam, I think: ” But remember, each of these dividends was subject to income tax. So before summing them up, you can deduct the total income tax you paid on those dividends.” Was a bit confusing. The key is, it’s the Net notional dividend that’s reinvested into the fund, not the gross figure. So when you are calculating the aggregate dividend, you sum the net figures. The principle is that these dividends are classes as income for tax purposes, not capital.

    Teaches me for commenting on my phone.

  • 53 ianh March 29, 2018, 6:33 pm

    @vanguardfan yes I agree – I mentioned in my first post the only directly comparable fund I found (Halifax Fund of Investment Trusts A) was not a good match, and VWRL may be better. I have a lot of that in my ISA and SIPP anyway though. Explicitly including small cap fund in my portfolio is based on my reading of Michael McCLung’s book Living off Your Money, whose recommended portfolio includes significant global small cap elements. I’m loathe to tinker too much TBH and am fairly happy with how I have things set up. But I have to sell for annual drawdown and to make an ISA transfer in the first few months of the new tax year anyway.

  • 54 xeny March 29, 2018, 7:44 pm

    @The Rhino, I think iWeb automatically calculate a running average of any asset you’ve bought in multiple tranches, so that saves some work.

  • 55 The Rhino March 29, 2018, 8:30 pm

    Yes it does. Very handy.
    I took a punt and queued up two sales of 20k each to move into the ISAs
    I did double check the BTL CGT situation

  • 56 Derek The Elephant March 30, 2018, 9:11 am

    Ok, interesting comments. It seems I’m in the same boat as a few others who hold an Acc fund out with a tax shelter. I only hold one fund…Vanguard LS80. My account is with Charles Stanley & I’m looking at the 16/17 Tax Certificate they provide & trying to understand what figures I should be using for both CGT & Income Tax calculations.

    There are two columns, ‘Dividend paid’ & ‘Equalisation’.

    So for Income Tax… is it simply a case of using ‘Dividend paid’ for calculations? Anyhow, this is below the £5000 tax free allowance for dividends so I don’t think I owe HMRC in this respect unless I’m missing something?

    And I think CGT = (Sales Proceeds-Dividend paid) – (Purchase costs- Equalisation) ?

    From my own calculations using Trustnet dividend figures, simply multiplying the dividend (Trustnet figure) by Units Held on the dividend date results in a figure which equals (‘Dividend paid’ +‘Equalisation’) from the Charles Stanley Tax Certificate. I just feel this is a bit odd and perhaps my CGT formula above is wrong in respect of the ‘Dividend paid’ figure?

    Anyway, I guess I’ve learned that Inc funds are the way ahead in future for non-tax sheltered holdings! But any light shed on the above would be appreciated.

  • 57 Kris Wragg March 30, 2018, 10:16 am

    So to further the discussion with @Xyz with regards to using GNUcash for my accounts, it seems I wasn’t using it correctly but it can do them in accordance with section 104 holdings.

    The issue is by default it will create a new ‘lot’ for each purchase and do FIFO which is suitable for US tax rules, this yields incorrect CGT calculations for UK. But if you have a single lot and put all buys and sells in that then it seems to calculate the correct results based on some tests with this:

    http://www.cgtcalculator.com/calculator.aspx

    I think you’d need to do a bit more if you have purchases before 2008 though as slightly different rules? But that doesn’t effect me.

  • 58 Haphazard March 30, 2018, 3:37 pm

    For those of us who despair at the ACC fund calculations… can we fairly assume that we can hand this lot over to a high street accountant? Lots of them round where I live advertise self-assessment, in general terms – is the general idea that they understand all this investment stuff? Or is it a more specialist thing?

    Don’t want to hand over to someone who knows even less than I do.

  • 59 tom March 30, 2018, 4:59 pm

    Haphazard – hard to comment as everyone’s different, but in my experience, a lot of tax accountants, even at Top 10 firms, won’t know much about investments generally. If presented with a situation, a good accountant will look it up (or rather, get a junior to look it up), but this can rapidly create an expensive bill.

    It’s up to you, but if you’re a regular Monevator read, have the right articles on Acc Funds, and have one or two free evenings, I’d say you’d probably be better off working it out yourself.

    It is not fundamentally difficult, just extremely fiddly, and in my experience requires time and (sometimes a lot of) patience.

    In summary: a high street accountant may well know less than you.

    p.s. Thanks to TI for the Acc articles – they’re very much appreciated – it is quite scandalous really that you are the only person I can think of who has managed to explain what to do in ‘plain english’. Thanks for nothing Office of Tax Simplification!

  • 60 Vanguardfan March 30, 2018, 6:15 pm

    My tax accountant, who I think is very good, seems to be pretty clued up on managing tax on investments, and definitely knows more than me.

  • 61 Hospitaller March 30, 2018, 8:08 pm

    Above mostly focuses on capital gains on shares.

    Does anyone know if the following work re property? Let’s suppose you once bought a second property for say £100,000 and its now worth £200,000. Can you each year sell a chunk to a company owned by yourself and in that way gradually eliminate the capital gain, using your annual capital gains allowance? I know if you sell the lot to your own company, then that causes a capital gains taxable event. But is there some HMTC rule to stop you using the annual capital gains allowance in this way?

  • 62 Atlantic March 31, 2018, 12:35 pm

    I too am whistling and looking down at my feet. You’re not the only one. To be fair there seemed no pressing reason in days of yore to ISA (or PEP) my all. There was no higher rate tax to pay on dividends in my case. The annual CGT allowance whispered that in retirement I would be able to stagger disposals to get at any ill gotten gains tax free. There may have also been an ISA/PEP platform charge? In my case the root cause was simply admin:- my savings scheme didn’t originally offer monthly direct debits into an ISA – I continued with my monthly direct debits into a non-tax favoured savings scheme for some 20 years. The wake up call for me was the dividend allowance coming down to £2,000 – I had no tax to pay when the allowance was £5,000. I’ve now spent hours researching the capital gains tax base cost of my shares to work out how many shares to sell to use the capital gains allowance and the first tranche is sold and the proceeds waiting on 6 April 2018 to put it into an ISA:- this will be the first of a few Bed and Isa-ing exercises. All completely avoidable I know but no crystal ball at the time that I knew of forecast the dividend allowance. On the issue of new legislation having adverse effects on perfectly reasonable planning/transactions done years ago, I now find that the AVCs I put in for most of my years into a DC pension scheme may create a lifetime allowance charge when I come to 65 or more likely 75. A nice problem to have I hear you say, but would I have paid AVCs in for all those years had I known that the lifetime allowance charge was on the horizon ? – almost certainly not. I wonder what’s next for the sitting ducks of retirement taxees? How about dividends in ISAs remaining tax free by virtue of a 0% tax rate but using up your basic rate band?

  • 63 John B April 1, 2018, 7:44 am

    When doing CGT defusing disposals I try and keep the gain £500 below the limit to avoid being caught out by my mistakes, and normally below 4*allowance so I don’t need to show my working to HMRC. So glad I’v finally disposed of the M&G monthly savings plan that had quarterly reinvestment of dividends. 16 transactions per year!

    Make sure your funds are UK reporting, even if Irish domiciled, as in some jurisdictions capital gains are counted as income for tax purposes by HMRC

  • 64 Boltt April 1, 2018, 11:12 am

    @hospitaller

    I have a few BTLs and also wondered if I could sell a % annually to a ltd company to manage Tax.

    So far Ive not found any useful info, but if I do find some I will post.

    My daughter lives in one of the properties and I also wondered if I could gift a percentage every year to manage IHT.

    Nice problems to have!

  • 65 Hospitaller April 1, 2018, 12:37 pm

    @Boltt “I have a few BTLs and also wondered if I could sell a % annually to a ltd company to manage Tax. So far Ive not found any useful info, but if I do find some I will post.”

    Indeed, a nice problem to have but also a bit of a pain to manage. Yes, please do let me know if you find anything on that as a way to manage capital gains tax.

  • 66 Boltt April 1, 2018, 3:28 pm

    Piecemeal disposal of assets/property to reduce CGT:-

    These two websites seem to indicate partial sales of property is possible – the property will probably need to be mortgage free and some valuation fees will apply. But seems like a fine idea to me.

    https://www.wealthprotectionreport.co.uk/public/Piecemeal_disposal_to_utilise_CGT_annual_exemption_.cfm

    https://www.accountingweb.co.uk/any-answers/gift-my-btl-property-to-children-in-stages

    In true monevator style DYOR, no warranties provided.

  • 67 Benjamin Fabi April 2, 2018, 10:56 am
  • 68 Haphazard April 3, 2018, 11:59 am

    Thanks that’s a very helpful link on the tax voucher…
    The local accountant in town charges £360+VAT for self-assessment – certainly makes me think again about doing my own.
    I noticed last year that you can’t just stick “dividends” in a box, if I have understood rightly. Because if you have any funds domiciled elsewhere e.g. in Ireland, presumably that is “foreign” income, for the foreign pages?
    There’s also a Monevator article in the archives on “excess reportable income”… so many things to potentially get wrong!

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