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Tax efficient investing in the UK (or what order to put things into an ISA or SIPP)

Can’t fit all your investments into your ISA and SIPP tax shelters? Then you’re going to have to make some choices. Happily, the pecking order for maximum tax efficiency is clear cut.

In order of most important-to-shelter to least:

  • Offshore funds without reporting fund status
  • Bond funds
  • REITs
  • Individual bonds
  • Income producing equities
  • Foreign equities (arguable)

Tax efficient investing for your ISA or SIPP

To see why this sequence is likely to suit your circumstances, let’s just quickly tee up the relevant tax rates from April 2016:

 2016/17 Income tax Dividend tax Capital Gains Tax
Tax-free allowance £11,000 £5,000 £11,100
Basic rate taxpayer 20% 7.5% 18%
Higher rate taxpayer 40% 32.5% 28%
Additional rate taxpayer 45% 38.1% 28%

At a glance we can see that income tax is the nastiest while capital gains tax (CGT) is generally the most benign due to the high personal allowance (you can use your spouse’s too) and the ability to offset gains against losses.

Before we get into the guts of it, I’ve got to dish up some caveat pie:

  • This article is written for the 2016/17 tax year, so I’ve used the new dividend income tax rates.
  • Information on the CGT rate for 2016/17 is currently unavailable.
  • Interest is taxed at your usual income tax rate and basic rate payers will have a £1,000 personal savings allowance from April, reduced to £500 for higher rate payers and nil pounds beyond that.
  • If your interest or dividend income or capital gains pushes you into a higher tax band then you will pay a higher rate of tax on the protruding part.
  • I’m restricting this article to mainstream investments – no kinky stuff.
  • If you’d like a quick refresher on the tax deflecting powers of ISAs and SIPPs, well, just click on those links.
  • And if you’re not sure which is best for saving then try our take on the old ISA vs SIPP debate.

Non-reporting funds

Offshore funds that do not have reporting fund status are taxed on capital gains at income tax rates. As you can see in the table above that’s a hefty tax smackdown. Worse still, your capital gains allowance and offsetting losses are knocked out of your hands by HMRC like the school bully taking your lollipop.

If your offshore fund or ETP doesn’t trumpet its reporting status on its factsheet then it probably falls foul and should be stashed in your ISA or SIPP.

It’s worth double-checking HMRC’s list of reporting funds. Around 25% of offshore funds / ETPs available to UK investors don’t qualify.

It is possible for a reporting fund to lose its special status, therefore you could put all offshore investments in tax shelters, if you like to head off unlikely but plausible worst case scenarios.

Bond funds

Bond funds / ETFs are next into the tax bunker because interest payments are taxed at income tax rates rather than as dividends. Any vehicle that has over 60% of its assets in fixed income or cash at any point in its accounting year falls into this category.

Real Estate Investment Trusts (REITs)

REITs pay some of their distributions as Property Income Distributions (PIDs). PIDs are taxed at income tax rates not as dividends. Get ‘em under cover.

Individual bonds

Individual bonds are liable for income tax on interest just like bond funds. The only reason that bonds are slightly further down the list is because individual gilts and qualifying corporate bonds do not pay capital gains tax.

Income producing equities

The dividend tax situation has suddenly got a lot worse for UK investors, so high-yielding shares and funds should duck under your tax testudo next.

By all means prioritise protection for your growth shares if you think CGT is the bigger problem, but bear in mind you can defuse capital gains every year and you can always defer a sale.

Foreign equities

It isn’t necessarily a priority to get overseas funds and equities sheltered but there’s a tax-saving wrinkle here that only works with SIPPs. The issue is withholding tax which is levied by foreign tax services on dividends and interest you repatriate from abroad.

Some withholding tax will be refunded as long as you fill in the right forms. For example a 30% tax chomp on distributions from US equities becomes a mere 15%.

Foreign investments in SIPPs can have all withholding tax refunded but only if your broker is on the ball. You’d need to check. ISAs don’t share this feature.

If you hold foreign equities outside of a tax shelter then you can use whatever withholding tax you have paid to reduce your UK dividend bill.

So in the case of US equities, a basic rate taxpayer could use the 15% they’ve paid in the US to reduce their 7.5% HMRC liability to zero.

In other words, only higher rate / additional rate taxpayers should consider sheltering US equities in ISAs. Everyone can benefit from the SIPP trick, though.

Bow-wowing out

It only remains to say that this is generalised guidance and tax is a byzantine affair. Please check your personal circumstances.

Tax efficiency is important but whatever happens don’t let the tax tail wag your investment dog.

Take it steady,

The Accumulator

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{ 28 comments… add one }
  • 1 Topman July 21, 2015, 10:53 am

    @TA “Bond Funds”

    Does that exclude dividend (i.e. not interest) paying vehicles such as Invesco Perpetual Enhanced Income Limited, which is more or less wholly invested in corporate and government bonds?

  • 2 taccumulator July 21, 2015, 3:17 pm

    @ Topman – yes, the idea is to shelter first the investments in your portfolio that expose you to the worst tax rates. Though I wonder how your fund gets away with paying dividends if it’s more than 60% invested in bonds?

  • 3 MyRichFuture July 21, 2015, 3:20 pm

    This is a great article, TA, many thanks. If you’re clever with tax and know the rules, it will go a long way to boosting returns.

  • 4 Topman July 21, 2015, 5:20 pm

    @TA (post 2) “… I wonder how…..”

    It’s a closed ended investment company.

  • 5 grey gym sock July 22, 2015, 4:08 am

    all the points in this article are valid; but there are other ways of looking at it …

    an alternative argument, in simple terms: your tax-free space is valuable, so you should put assets with higher expected returns in there, and prefer to put assets with lower expected returns in a taxable account. then your tax-free space will expand, as the assets grow. this argument is more likely to be valid if you are investing over a long time (decades).

    specifically, equities and REITs have higher expected returns, and so (on this argument) should go in tax-free accounts; bonds have lower expected returns, so they should go in a taxable account, if something has to.

    a (very long, i’m afraid) concrete example:

    suppose you are investing £15,240 in equities and £15,240 in bonds today, 1 of which can go in an ISA, and the other in a taxable account.

    suppose the real return on equities is 5%. even in a taxable account, suppose you could avoid CGT by using your annual allowance, but you’d pay 7.5% tax on a yield of 2%, i.e. 0.15% tax per year, reducing returns to 4.85%.

    suppose the expected return on bonds is 2% in nominal terms (the yield to maturity is the best estimate of this), but that inflation will be 2%, so the expected real return is 0%. suppose the running yield on bonds is 3% (because they are priced above par), and in a taxable account you’d pay 20% tax on that 3%, i.e. 0.6% per year, reducing real returns MINUS 0.6%.

    so you can either have
    (1) £15,240 in an ISA, in bonds, compounding at 0% per year in real terms (though it will grow in nominal terms), + £15,240 in a taxable account, in equities, compounding at 4.85% per year;
    or
    (2) £15,240 in an ISA, in equities, compounding at 5% per year, + £15,240 in a taxable account, in bonds, compounding at MINUS 0.6% per year.

    which is better? (1) starts out ahead, but (2) eventually catches up, in year 29, and then keeps pulling further ahead.

    that was using rates for a basic-rate taxpayer.

    a higher-rate taxpayer would pay 32.5% on dividends, and 40% on interest. giving them a choice of
    (1) £15,240 in an ISA, in bonds, compounding at 0% per year, + £15,240 in a taxable account, in equities, compounding at 4.35% per year;
    or
    (2) £15,240 in an ISA, in equities, compounding at 5% per year, + £15,240 in a taxable account, in bonds, compounding at MINUS 1.2% per year.

    again, (1) starts out ahead, and (2) overtakes it, but in this case it does so sooner, in year 13.

    (and additional-rate taxpayers can do their own calculation :).)

    you could get different results by changing my assumptions (specified above) about rates of return, yields, and whether you can avoid CGT. feel free to debate those assumtions (if this post hasn’t put you to sleep yet).

    the tax rates used above are the ones that apply after various allowances have been used up:
    – personal savings allowance (£1,000 or £500 or nil);
    – personal dividend allowance (£5,000); and
    – zero-rate starting-rate savings band (£5,000) (only applicable to ppl earning less than £16,000)

    OTOH, what if *none* of those allowances have been used up? (the above investments, totalling £30,480, won’t use them up immediately, unless you’re an additional-rate taxpayer – until you do the same thing for a few more years.) in that case, there is no immediate tax difference from what goes in the ISA. in which case, i’d put the equities in the ISA, because that will tend to expand the ISA space, since equities are expected to grow faster.

    however, some ppl will have enough in taxable bonds to use up the personal savings allowance (assuming bonds pay 3% income, that is £33,333 in bonds for a basic-rate taxpayer, or £16,667 for a higher-rate taxpayer); and not have a zero-rate starting-rate savings band; and not have enough in taxable equities to use up the personal dividend allowance (assuming equities pay 2% income, that would take £250,000 in equities).

    these ppl might well be better off making their next bond purchases in ISAs and next equities purchases in taxable.

    and other ppl will have a different combination of unused allowances.

    and then there are ppl who would be better off rearranging what they hold where, but who would incur costs to do so (transaction costs, or CGT from realizing taxable gains). 1 question to ask in this case is: how many years would it take for the more efficient set-up to recoop the costs of the rearrangement?

  • 6 The Investor July 22, 2015, 10:45 am

    @grey gym sock — Agreed. Ultimately if shares deliver 2-4% real returns above bonds over the long-term, then on a 20-30 year view you’d likely have been best off stashing them in your shelters, ahead of say bonds and cash, even after the relative tax differentials on income/dividends.

    Playing with a compound interest calculator will show us that.

    However ultimately everyone will have to do their own sums.

    e.g. Anyone who is squeezing their shelters to the rim by putting say £15,000 into an ISA annually and £40,000 into a SIPP is *likely* to be fairly high-earning and/or wealthy (ignoring spouses/lump sums/outliers*) and hence at risk of income pushing them into higher tax brackets, while at the same time perhaps feeling more able to risk higher allocations towards equities for the long-term.

    So no trivial answers, but I think this is a strong and simple starting point and overview.

    *Yes, they may be late pension starters or risk-averse or just had an inheritance etc etc etc. As I say, broad terms are only a starting point with taxes.

  • 7 Baby Boomer in Croydon July 22, 2015, 8:09 pm

    Retired investors might also like to consider investing in a Stakeholder pension, even if they pay no tax, basic tax or higher tax the Government will contribute their share to the pension, and a higher rate taxpayer can claim the difference back.

    It falls into the category of invent and leave it for the kids as its outside your estate for inheritance tax, and its their if you need it for care fees. You can even get 25% back tax free and draw down the rest at £1 pa. The residual value being available for the kids.

    The sting in the tail is tax and this is where I am not sure but assume it is taxed at the marginal rate of the recipient, or they get at lease what you have invested minus tax, i.e what the government contributed.

    Perhaps you could provide some insight on the last para as I cannot understand the pension inheritance rules.

    Thanks and a great piece of work. All my investments are in iSA’s as I started transferring assets when they were Peps and TESSA’s

  • 8 Jeff July 22, 2015, 8:43 pm

    If bonds have lower expected returns, I would suggest the best approach would be to not hold any of them.
    Currently I hold equities and cash.
    Using the full ISA allowance is a given. After that, I’ve been trying to put dividend payers in my ISA and stocks which are more likely to generate a capital gain in my non-sheltered account. Then I aim to use the capital gains tax allowance each year.
    Now I can also target the £5k dividend allowance.
    Any income over the 40% tax threshold gets paid into the SIPP.
    [I have very low living costs]

  • 9 The Investor July 23, 2015, 9:10 am

    If bonds have lower expected returns, I would suggest the best approach would be to not hold any of them.

    This statement sounds right but will be bad advice for most people.

    How could it be modified to be less wrong?

    One might say (with my additions/changes in bold):

    If bonds have certain lower returns, I would suggest the best approach would be to not hold any of them.

    Or one might say:

    If bonds have lower expected returns, I would suggest that if the aim is maximize your potential return (at the risk of doing worse than with a more balanced approach) then the best approach would be to not hold any of them.

    “Expected returns” from both equities and bonds is just the middle number sitting in a range of possible returns, as you probably know. Diversification can enhance returns whilst reducing risk in a portfolio. And the reason you own bonds is not primarily for their returns, anyway.

    (Don’t get me wrong, I own almost no bonds either, just a few special situation plays, and like you hold cash instead. But I do so knowing that I am increasing the risk of doing worse in the pursuit of doing better. It’s an explicit trade-off. 🙂 )

  • 10 helfordpirate July 23, 2015, 1:20 pm

    Useful article. (And excellent comment from GreyGymSock.)

    I think the role of allowances in determining how to locate assets classes is also quite complex!

    In the accumulation years, when many here are perhaps higher rate tax payers, it is relatively straightforward as they unlikely have any zero-rate band and will only have a small savings allowance.

    As I approach the distribution phase, I can see there are many more options especially for a couple to maximise tax free income. I have generally kept bonds in ISA and put equities in my wife’s name (as non earner) where the dividends have hitherto attracted no tax. But soon it will make sense to have bond funds outside my ISA as, with no other income, I will be able to take the personal allowance from my SIPP plus £5000+£1000 from bond and cash interest (that’s a lot of bond funds at today’s rates!) and still have a £5,000 allowance for dividends (I believe dividend income is not added to determine your entitlement to the zero-rate?). So £21k tax free and similar on my wife’s side.

    So I will start to move bonds back out of ISA’s in the next few years as my earned income starts to fall away.

    BTW I have seen reference that “savings-interest” includes interest from unit trust and OEICs, but not actually explicitly interest from bond ETFs which while open ended investments are classified as foreign interest. Anyone know for sure that bond interest e.g. IGLT, INXG counts as “savings-income”?

  • 11 taccumulator July 23, 2015, 8:36 pm

    @ Topman – I wonder why close ended funds would be treated differently? I haven’t come across any advice mentioning this exception before. Do you own these funds and they pay out as dividends? I’m not trying to be difficult, it’s just I’m finding it remarkably difficult to get any clarity on this point.

    @ Helford – I’d be astonished if UCITS, UK reporting ETFs were treated differently but it’s possible. I haven’t seen anything yet that definitively says bond interest qualifies for the personal savings allowance.

  • 12 Topman July 23, 2015, 10:30 pm

    @TA (post 11)

    I don’t know the why but the what is definitely shares/dividends, with the current status of Invesco Perpetual Enhanced being ex-dividend (See http://www.hl.co.uk/shares/shares-search-results/i/invesco-perpetual-enhanced-income-ld-ord-5p).

    I don’t hold Perpetual Enhanced but I do hold the dividend paying Henderson Diversified (see (http://www.hl.co.uk/shares/shares-search-results/h/henderson-diversified-income-ord-npv) which invests in secured loans, asset-backed securities, high yield bonds and investment grade bonds, and with both of these companies included in the 15 investment trusts listed on Trustnet as being Asset Class “Fixed Interest”.

  • 13 Topman July 24, 2015, 2:57 am

    @TA

    BTW, forgive my impertinence but are you and “taccumulator” one and the same, as rightly or wrongly I assumed that you were? Intriguing how this kind of thought can wake a person at 3am ~:-).

  • 14 The Accumulator July 24, 2015, 9:27 am

    Hi Topman,

    taccumulator is The Accumulator in email address form! Somehow seems to have become my username due to auto-form filling inattentiveness on my part.

    Just to clarify this close-ended business to the nth degree. When Henderson’s pays a distribution does it come with the 10% tax credit? In other words, does it definitely pay as a dividend?

    I ask the question because OEIC / Unit Trust bond funds can be described as ex-dividend even though they’re paying interest as far as the taxman is concerned. And also because any vehicle will just pay you the distributions but how they are declared for tax purposes is down to the individual investor.

  • 15 Topman July 24, 2015, 12:18 pm

    @TA

    All interesting (no pun).

    Situation report:-

    1. Spoken today to iWeb, my dealing platform, and their back office says “definitely dividend” but is that the right answer to the wrong question?

    2. Spoken today to the HDIV Company Secretary, at BNP Paribas in Jersey, and awaiting his call back.

  • 16 Topman July 24, 2015, 12:31 pm

    @TA (post 14) “….. 10% tax credit?”

    I only bought fairly recently, since when they have been betwixt and between vis à vis “dividends” and so the 10% answer is “pass”.

  • 17 helfordpirate July 24, 2015, 3:05 pm

    Just following up my own question for those who may follow….

    Working through SA110 Calculating Your Own Tax, I can confirm that box 4 on the Foreign Pages which is the total of Foreign Interest received is added to “Savings Income” to which the zero-rate allowance applies.

    So in conclusion bond ETFs (whose interest is totalled in box 4) would seem to qualify as savings-income for the £5k zero rate and £1k savings allowance.

  • 18 Topman July 24, 2015, 5:02 pm

    @TA

    The HDIV Company Secretary at BNP called back, and was both pleasant and helpful. Interestingly, with HDIV being Jersey based, he firstly pointed me at the very same AIC guide which I linked to in the How Dividends are Taxed item here (post 29) and specifically the section in the guide headed “What about overseas dividends?”

    More importantly, he said that he had spoken directly to “Henderson” (which I take to mean the trust manager Henderson Investment Fund Ltd) as a result of my query, and that HIFL had confirmed that the HDIV dividend when paid does have the 10% tax credit “attached”.

    Also, in the interim I had spoken to the investment advice service at HL, and they too said that the HDIV “dividend” is correctly so called, and is not interest by another name.

    So, I’ll dink this one back over the tennis net to you!

  • 19 Topman July 24, 2015, 5:16 pm

    @TA

    Correction: Henderson Investment Funds Ltd.

  • 20 The Accumulator July 24, 2015, 6:42 pm

    @ Topman – well, you’ve certainly lived up to your name there. Thank you very much for your sleuthing.

    I wonder if it’s because when you buy into an IT, you’ve essentially bought shares in the IT (hence you pay stamp duty) rather than the underlying assets.

    When the IT pays a distribution, it’s classified as a dividend because you’re receiving a share of the performance of the company i.e. the IT.

    I haven’t found anything yet that states this in black and white but seems plausible.

    @ Helford – thank you for following up on that one. Reassuring to hear we haven’t got yet another complication to deal with.

  • 21 Topman July 25, 2015, 8:43 am

    @TA

    On further reflection, before I hunker down for some serious Formula One practice/qualifying watching, it occurs to me that the reason why “fixed interest ITs” are deemed to pay true dividends, rather than “interest dividends”, may be because whilst OEIC/unit trusts are required to pay out all of the year’s income in that year, investment trusts are not so required, and may instead and very often do take some of any year’s income to revenue reserve (I believe permitted up to 15% in any one year), thus enabling these ITs to draw on those reserves when required to smooth/maintain/enhance their dividend pay-outs, as evidenced by the extent to which ITs generally were better able to ride the waves in 2008/9.

    Thoughts?

  • 22 Topman August 10, 2015, 1:04 pm

    @TA

    I’ve “sleuthed” this further now, and despite what I reported above when quoting various sources, I’m essentially confident that the “dividends” from ITs investing predominately in the fixed interest arena are in fact interest distributions and are potentially taxable as such.

    See http://www.invidion.co.uk/internal_taxation_of_investments.php where it says in the footnote which follows the table headed “Personal Tax liabilities applicable to holders of these investments”, “….. allow an investment trust that invests in interest bearing assets to receive a tax (corporation) deduction for any interest distributions made. This will effectively remove any corporation tax liability that would otherwise arise on distributed interest type income. Where (such) an interest distribution is made by an investment trust it will be treated in the hands of the shareholder as if it was a payment of yearly interest …..”

    If I’m right (usual caveat of course that I’m not an investment advisor), then you may want to indicate it in your “most important-to-shelter” paragraph at the head of the post.

  • 23 The Accumulator August 16, 2015, 4:35 pm

    @ Topman – thanks very much for deep-diving into this one. Is the change you’re advising something like this:

    Bond funds / Fixed interest ITs

  • 24 Topman August 19, 2015, 12:12 pm

    @TA

    Yes, that’s what I recommend pro tem.

    I’ll be able to absolutely nail it when my first HDIV “dividend” arrives c.30 September, and I’ll confirm the situation then.

    Best T

  • 25 The Accumulator August 21, 2015, 8:53 pm

    Okedoke. I’ll make that change and if you can let me know when the divi comes in that’d be great. Cheers!

  • 26 The Accumulator September 19, 2015, 4:39 pm

    Two extremely useful comments from Old Grey Gymsock if you want to get into the weeds on the tax status of Investment Trusts. Be afraid…

    http://monevator.com/bonds-and-bond-funds-taxed/comment-page-1/#comment-722904

    http://monevator.com/bonds-and-bond-funds-taxed/comment-page-1/#comment-723018

  • 27 The Accumulator October 3, 2015, 9:12 pm

    Update on the epic investment trust saga from Topman. Looks like they pay out interest as dividends: http://monevator.com/bonds-and-bond-funds-taxed/#comment-725157

    Thanks, Topman!

  • 28 IanH July 25, 2017, 8:54 am

    Here’s a puzzle I can’t get my head around and I would appreciate anyone’s insight. I have a SIPP with a mixture of equities and bonds, and have an inheritance lump sum to invest. I can’t put anything significant into the SIPP as I am retired, and don’t want to, so to shelter the new increased bond element I want in my portfolio my ‘plan’ is to convert equities in the SIPP into bonds, and have a correspondingly larger part in equities in a tax exposed account, my genius idea being this will shelter the bond income from income tax as SIPP withdrawals are subject to income tax anyway.

    If the clarity of my explanation has left you baffled some vague numbers might help – say you want to set up a 50/50 bond/equity portfolio with all the bonds in a SIPP and all the equities tax exposed should it really be 50+x/50-x where x is related to the potential income tax on any SIPP withdrawals?

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