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.
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
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
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
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
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
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
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.
- 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. [↩]
- Also known as your ‘Annual Exempt Amount’, if only by HMRC. [↩]
- £119,700-£11,300. [↩]
- £219,700 – £21,680. [↩]
- £130,000-£48,967. [↩]
- x*2.197=£80,226, so x=£36,516. [↩]
- 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. [↩]
- £82,754+£35,980+£20,740+£73,744. [↩]