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The surprisingly savage way tax reduces your returns

Tax will take a huge bite out of your returns, if you let it.

Many Monevator readers strive to shave tenths of a percent off the running costs of their portfolios – as they should.

But the impact of paying tax on share gains or dividends can dwarf such noble cost curbing.

That’s why I bang on about avoiding tax more than might appear seemly.

If you’re paying tax on profits from share trades or on your dividend income, you’re probably throwing away money.

For some investors, paying tax is inevitable – perhaps because they’re rich enough to have lots of money invested outside of tax shelters, but maybe not rich enough to know (or be told) how to manage it.

Most of us though can postpone, reduce, or avoid paying tax by using ISAs and pensions as soon as we start investing, and by judiciously managing any unprotected capital gains and losses every year.

We can also become knowledgeable about tax on dividends, and hold our different assets accordingly.

Even if you can’t escape paying some tax on your investments, there can be a big advantage in delaying it, as I’ll show in a future article.

But how big a deal is paying tax on investments, really?

How tax reduces your returns

Let’s consider two investors, Canny Christine and Flamboyant Freddie.

(Sorry if you find these names cloying. It’s a requirement of the financial writing union to pick names like this when discussing 20-year returns.)

Let’s assume both of them inherit £10,000 each. Not to be sneezed at, certainly – though Freddie wouldn’t be against shoving a crisp £10 of it up his nose in certain circumstances – but nothing that’s going to see HMRC unleash a plainclothes officer and a tax evasion detector van.

When it comes to tax, Flamboyant Freddie can’t be bothered to know. He thinks ISAs and pensions are for people who buy Tupperware in bulk from mail order catalogues. So he regularly trades his shares in a vanilla broking account, and boasts about his winning picks to friends who put up with him because he’s always good for a pint.

Freddie is my kind of pal, but he’s not my kind of investor.

Enter Canny Christine. Christine uses ISAs from day one. She can put her whole £10,000 into a share ISA right away, meaning her investment is entirely protected from tax forever more. So she does so.

What happens to their respective loot after 20 years?

Everyone’s tax situation is different. The rate of tax on dividend income and on capital gains depends on what you earn, so there’s no point me doing specific calculations. Tax rates have changed multiple times in the past 20 years, too.

So let’s simply assume:

  • Our two heroes both make 10% a year returns.
  • Freddie pays tax on his returns at a rate of 25% every year.
  • Canny Christine has no tax to pay.

Here’s how their money compounds over 20 years:

Year Freddie (taxed) Christine (no tax)

0

£10,000

£10,000

1

£10,750

£11,000

2

£11,556

£12,100

3

£12,423

£13,310

4

£13,355

£14,641

5

£14,356

£16,105

6

£15,433

£17,716

7

£16,590

£19,487

8

£17,835

£21,436

9

£19,172

£23,579

10

£20,610

£25,937

11

£22,156

£28,531

12

£23,818

£31,384

13

£25,604

£34,523

14

£27,524

£37,975

15

£29,589

£41,772

16

£31,808

£45,950

17

£34,194

£50,545

18

£36,758

£55,599

19

£39,515

£61,159

20

£42,479

£67,275

(Note: Another way to envisage this is to compare annual returns of 7.5% and 10% with a compound interest calculator).

As you can see, paying tax on gains every year makes a pretty stunning difference.

  • After 20 years, Freddie’s pot is worth £42,479. He feels pretty good about quadrupling his money, thank you very much.
  • However Canny Christine has £67,275!

Christine has an enormous 58% more money than Freddie, due to her prudence in sheltering her portfolio from tax.

Easy ways to avoid paying tax on share profits and income

While I think it’s fit for purpose, my illustration isn’t overburdened with realism.

You could argue Freddie would be unlikely to ever pay capital gains tax, for example, on such a small portfolio.

On the other hand, if he were a higher-earner who ran a high-yield portfolio and reinvested his dividends, then those dividends would be taxed at 25%. So it’s certainly not crazy to use a tax rate of 20% over the two-decade period.

Besides, most dedicated investors will eventually invest far more than £10,000, so capital gains tax will become more of an issue over time.

In the real-world, most people save regularly every year, too, which can soon change your tax profile as your treasure pile grows – especially if your income increases.

I’d guess most salary earners who are canny enough to start investing in their 20s and early 30s will end up as higher-rate taxpayers, for example.

So don’t get obsessed about the details. The clear lessons are:

  • Paying tax on dividends or share gains can take a big chunk out of your returns.
  • Most of us can use ISAs or pensions to shelter our savings from tax, provided we start early enough in our investment adventure.
  • Those with very large sums invested outside of ISAs or SIPPs should read my article on defusing capital gains and make the most of their allowances.
  • If your ISAs are stuffed full and you can’t or don’t want to put more money in a pension, you might want to consider holding low-yielding shares in unsheltered accounts and save your ISAs for your higher-yielders, especially if your investing horizon has decades to run. (This is equally true for passive investors. Check the yield on your ETF or index fund, as they do vary quite a bit. Remember that Accumulation funds accrue tax, too).

The tax benefits of ISAs and pensions are theoretically the same, but the latter have a few perks for most people that might make them more attractive – a tax-free lump sum, and for higher-earners the likelihood of a lower tax rate in retirement – at the cost of more restrictions.

Personally I use a mix of ISAs and pensions, and intend to favour the latter as I get closer to retirement and the restrictions/regulatory risks recede as an issue.1

Not too taxing

Hopefully you think this is all perfectly obvious and you already use ISAs and pensions yourself. Subscribe to Monevator if you haven’t already, as you clearly belong here.

However I still regularly hear people saying they don’t need a tax shelter, perhaps because of small initial sums or because of the annual fees.

But if you’re going to be a successful investor, you do.

In a follow-up article I’ll look at the benefit of deferring your capital gains as another way to end up with more money. Subscribe to ensure you get it!

  1. Also note that you can hold AIM shares in a SIPP, but not in an ISA. []

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{ 17 comments… add one }
  • 1 Ethan's Money September 11, 2012, 7:15 pm

    An excellent post – it’s frightening how much the taxman can eat up over time (although it would be a challenge to earn a consistent 10% pre-tax yield in the first place!!).

    The other thought entered my head upon reading the article was the important contribution that re-invested dividends and compound interest make to capital growth. Without yield, your capital growth is constrained.

    A strange and annoying phenomenon has occurred online, whereby some bloggers have decided that dividends and interest are “passive income”. Nope. It’s likely that any yield is partly needed to offset the erosion of value through inflation, partly a payment for taking on investment risk (a risk premium) and partly compensation for not spending your money immediately (taking into account the ‘time value of money’).

    If you treat yield as “passive income” and spend it, all you are doing is depleting your capital base.

  • 2 RetirementInvestingToday September 11, 2012, 10:09 pm

    Great post. Baked into the cake taxes, which aren’t sensible to crystalise, on some of my longer term investments are exactly the reason it’s taken me a while to get my average expenses down to 0.36%. I’m going to continue to chip away at it. My method is to harvest the dividends from those higher fee investments and reinvest into my low TER variants.

    Great time to be talking about compounding also. On the weekend I was also looking at compounding by talking about my 2007 example of having to make a choice between DIY Monevator Style Investing vs Financial Planner Investing. I still feel I made the right decision.

    Cheers as always
    RIT

    BTW. Love the “Canny Christine and Flamboyant Freddie”. A lot better than my Average Joe…

  • 3 The Investor September 11, 2012, 11:39 pm

    @Ethan — Thanks for your comments. The 10% compounded per year is just an illustrative figure chosen for simplicity, but I don’t think it’s utterly far-fetched. For many years 10% was considered the ballpark nominal return from UK equities, although the past dozen rough years has knocked it down a couple of percent.

    I agree that dividends can be a powerful element of investing — you won’t get rich spending instead of reinvesting them, certainly 🙂 — but it is perfectly possibly to compound your wealth without them. There are plenty of shares, trusts, and even ETFs that have gone up many times over without ever paying out a penny.

    As I wrote in my recent article on earnings yield, it’s how your underlying investment performs that really matters. If the company can’t re-invest excess profits better than you, it should return it via a dividend. (In contrast it can get a higher return than you can, for the same risk, it should do — the classic no-yielding growth share example of the past 10 years would be Apple that has made many investors wealthy, although it’s finally started paying a dividend now its got more cash than California…)

    @RIT — Yes, rolling up capital gains for as long as possible is definitely another tax-avoiding strategy, as I’ll address in my next post. As you imply, it does make changing positions fiddly, as well as much else, however, so anyone who can use ISAs or pensions instead should do so, in my view. Thanks for your generous review!

  • 4 Neverland September 12, 2012, 9:09 am

    If you don’t want to pay tax in the UK you simply buy a house for cash and live in it

    No income tax on the rent saved, no CGT

    Council tax you would be paying anyway if you were renting it

    Of course, first of all you have to have enough money to buy a house for cash….

  • 5 The Investor September 12, 2012, 9:34 am

    @Neverland — Agreed, house buying in the UK is very tax efficient, even though explicit mortgage interest relief etc was scrapped years ago for home owners. (They still have it in the US and Australia…)

  • 6 Luke September 12, 2012, 9:46 am

    Good article which really spoke to me.

    I’ve just got back on the investing horse after liquidating just about everything when my wife and I bought our home in March and I can’t see the reason why anyone paying basic rate tax *wouldn’t* make use of either an ISA or pension to reduce tax.

    The affect of fees on my tiny initial investment of £50/mth into the Vanguard LifeStrategy 100 fund at this point is already pretty savage at this point – why compound it further by leaving myself exposed to more tax?

    It might be a small amount now, but it won’t always be and it’s important to start as you mean to go on.

  • 7 SemiPassive September 12, 2012, 8:37 pm

    Neverland, don’t forget stamp duty – they get you one way or another, especially on anything over 250k as it leaps from 1% to 3%.
    But agreed its a good thing there is no capital gains tax on a primary residence. And as long as the LibDems don’t win the next election council tax is not as bad as property taxes in some other countries that are directly related to the current value.

    I have zero taxable assets, primary residence with an offset mortgage (tax free cash savings) and everything else in ISA and SIPP wrappers. Makes tax returns a lot simpler on top of everything else.

  • 8 Lupulco September 12, 2012, 9:40 pm

    Interesting article, Cash ISA’s fine for rainy day money, but Equity ISA’s? yes you can save some tax but sometimes the cut/commission the ISA provider wants almost eats up the tax saved in the first place, plus it lacks flexibility.

    Anyway 10% tax on dividends is better then 20% on % from cash savings plus CGT on shares is tax free up to the current government threshold, which i don’t exceed as i just invest as a hobby not for need.

    Three aims, beat the FTSE, done it. Beat what i can get from a cash ISA , done it. Beat RPI + 1%, done it. So i am happy with my lot, i don’t invest enough to lose sleep over if it falls in value and never invest more then 5% in any one stock.

    I rely on the Rothchild and JP Morgan school. Regular dividends [if a Company does not have the discipline to pay a reasonable, well covered dividend, i ignore it] JP Morgan on being asked what will the stock market do tomorrow? I answer was fluctuate.

    Keep up the good work.

  • 9 Neverland September 12, 2012, 9:47 pm

    @semi

    Stamp duty is 5% on a million pound house

    Income tax top would be 20/40% on the annual income you might buy instead to pay the rent

    Not really a contest is it? 🙂

  • 10 Ric September 12, 2012, 10:34 pm

    One other benefit I love about ISA is the lack of paperwork when it comes to the tax return, especially if working out CGT on DRIPs, rights issues, etc.

  • 11 The Investor September 14, 2012, 9:38 am

    @Ric — You’re a man (or woman!) after my own heart — fully agree ISAs are a lifesaver from a paperwork perspective.

    @Lupulco — I don’t agree I’m afraid. I use self-select ISAs as they used to be called (i.e. I buy shares, bonds, ETFs, funds etc within an ISA wrapper) and the fees vary from cheap to free (provided you trade 4x a year in the latter case).

    Mine have had flat fees, too, so regardless of how much money you hold you’re still only paying (for example) £40.

    It’s extremely easy to pay £40 in tax on a portfolio of shares. Even £10,000 invested passively in a FTSE tracker will generate around £320 a year in dividend income. For a higher-rate taxpayer, they’ll then pay £80 in tax — twice the ISA fees.

    And that’s just in the early years. As I show in the table above, it’s the compound impact that really hurts.

    Fair enough on the Capital Gains Tax issue if it’s above your threshold, but for ambitious young investors who save hard and are reasonably successful they will sooner or later regret not ISA-ing their equities. I have been shoveling money into ISAs as fast as I can since seeing the light in 2003, but I’ve still got as much outside of ISAs as in them, and the tax implications definitely distort my actions (or else I pay more tax).

    Still, if you’re strategy works for you, I’m not arguing with that. 🙂 Love your JP Morgan quote, which I’d never come across before:

    When asked “Mr. Morgan, what will stocks do?” the great man responded “They will fluctuate”

  • 12 Moneyman September 15, 2012, 9:39 am

    You can even get a tax refund by investing in a SIPP for a non-working family member, although this is limited to £2880 (giving an immediate 25% return).

    When you retire, take your tax-free lump sum from your pension, invest it, then from the income pay into a SIPP for yourself (with the same limit as above) and make another 25% return.

    http://www.the-diy-income-investor.com/2011/03/instant-25-return-uk.html

  • 13 Ian September 16, 2012, 4:12 pm

    What’s not been said is Canny Christine used her ISA nominee account. Her broker was inept, crooked and incompetent and committed fraud.
    Her broker went bust and took her shares with it. But worry not. They were ring-fenced in the nominee account and protected under the FSCS scheme.
    However her broker didn’t actually have the number of shares they claimed to have and she was left with nothing.

    Flamboyant Freddie, on the other hand, used a certificated broker and ended up on the company’s share register and so couldn’t get a tax free ISA with these.

    Canny Christine is destitute and on the street with nothing – but at least she paid no tax.

    Flamboyant Freddie has more money left than she does but less than she would have had in theory.

    The moral?
    Avoid ISAs (as long as it’s nominee based), pay your tax and sleep better at night.

  • 14 Loads O' money September 16, 2012, 6:21 pm

    @Ian
    Have you also considered closing your bank account, in case your banker is crooked and incompetent and committing fraud? And have you closed your credit card account in case your card provider is crooked and incompetent and committing fraud? What about your Electric company, maybe you will be better off with a slot meter, preferably your own?

    I could go on, but my serious point is most modern day living has some minor degree of risk, but careful selection of reputable providers, and diversification between multiple providers for larger sums should provide you with a good compromise between convenience and the safety of dealing only in cash and certificates.

    Also certificates are inherently vulnerable to loss & theft.

  • 15 The Investor September 17, 2012, 11:52 am

    @Ian — I am all for healthy paranoia, but personally I don’t worry too much about Nominee accounts. They’re the overwhelmingly common method of ownership nowadays, and as has been noted certificates can get mislaid, chewed up by a dog and so on. You can get new ones, but they’re hardly immune to fraud, either.

    Spreading my portfolio between multiple reputable brokers is protection enough for me. Possibly I might add a certificate holding of something I’d imagine holding forever just for diversity’s sake at some point, but it’s not a priority.

    Thanks for raising the thought though; others may feel differently.

  • 16 frustratedsaver September 21, 2012, 10:59 am

    A question for Ian. You mention “avoid ISA’s as long as they are nominee based” as a method of protecting your savings. Is that possible? I have been looking for a broker who will hold my ISA investments in certificate form but they all claim it is impossible as it takes the investment outside the tax wrapper.

  • 17 Dan October 1, 2013, 4:50 pm

    Just an update on the footnote: AIM shares can now be held in an ISA too.

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