Many Monevator readers rightly strive to shave tenths of a percent from the running cost of their portfolios. But some people – especially wealthier savers – ought to think even harder about tax-efficient investment.

That’s because the impact of paying taxes on share gains or dividends can dwarf all your cost-curbing in the long run.

Which is precisely why I bang on about mitigating your tax bill more than is entirely seemly.

Investment tax in the UK is a rich person’s problem

If you’re paying capital gains tax (CGT) on profits from share trades or on dividend income, you may be throwing away money.

For a minority of investors, regularly paying taxes on investments is inevitable. Perhaps they’re wealthy enough to have money leftover outside of their tax shelters, for example, yet not loaded enough to call on the UK’s legions of tax specialists to get creative.

But those lucky few aside, most of us can postpone, reduce, or even entirely avoid paying taxes on our investment gains by using ISAs and pensions.

We can also become knowledgeable about taxes on dividends and bond income, and hold our different assets in the most tax-efficient way.

If needed we can even judiciously manage our capital gains and losses every year on unsheltered assets, and defuse gains where possible. (Albeit the scope for the latter has been much reduced by the whittling away of the annual CGT allowance).

Like this, even if you can’t escape paying taxes on some of your investment returns, you might still try to delay the bulk until you’re retired, when you’ll probably be taxed at a lower rate.

How tax reduces your returns

How big a deal is paying tax on investments anyway?

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

(Sorry if these names are too cute. As members of the Financial Writer’s Union we’re officially required to pick kitschy sobriquets when illustrating long-term returns with an example.)

Let’s assume Christine and Freddie both inherit £10,000 each. Nothing to be sneezed at, certainly – though Freddie isn’t against shoving a crisp £10 of it up his nose in the right circs – but also not enough to see HMRC unleash a plainclothes officer and a tax evasion detector van. (Not that we’ll be suggesting anything dodgy, of course.)

Now, when it comes to tax Flamboyant Freddie can’t be bothered to know.

Freddie thinks ISAs and pensions are for people who buy Tupperware in bulk from mail order catalogues. He regularly turns over his shares in a no-cost share trading app. He boasts about his wins to his friends who put up with him because he’s always good for a pint.

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

Enter Canny Christine.

Christine uses ISAs from day one. She can easily put the whole £10,000 into a shares ISA right away, meaning her investment is entirely protected from tax forever more. And so she does just that

What happens to their respective loot after 20 years?

Two decades later

Everyone’s tax situation is different. The rate of tax on dividend income and capital gains depends on how much you have and what you earn. There’s no point me doing specific calculations.

Tax rates change all the time, too.

So let’s simply and arbitrarily assume:

• Our heroes each make 10% a year returns. We’ll ignore costs.

• 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: You can also envisage this by comparing annual returns of 7.5% and 10% using a compound interest calculator).

Paying taxes on gains every year makes a stunning difference:

• After 20 years, Freddie’s pot is worth £42,479. He feels pretty good about quadrupling his money, thank you very much.

• But Canny Christine has £67,275!

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

Even if Christine’s returns were taxed in the end – maybe if you were modelling pensions not ISAs – and at the same rate as Freddie, she’s still ahead.

A 25% tax charge on Christine’s £57,275 investment gain takes her final pot down to £52,956.

By deferring her taxes and keeping her capital unmolested to grow until Year 20, she’s left with very nearly 20% more money in her pot than Freddie.

Tax-efficient investment in practice

This theoretical example isn’t over-burdened with realism.

In reality, returns from investment – and hence whether and how you’re taxed – won’t be smooth.

Most investors will invest far more than £10,000 over their lifetimes. So capital gains tax and dividend tax will become more of an issue as portfolios grow.

An investor’s personal tax profile will also change over time. Not least due to investment gains and dividends if they invest large amounts of money outside of tax-efficient investment shelters! But also because they’ll probably earn an increasing income at work.

Most salary earners who are canny enough to start investing in their 20s will end up as higher-rate taxpayers. And tax rates than might seem trivial as a basic-rate payer, such as dividend tax, ramp up with your salary.

Gimme shelter

So don’t get obsessed about the details above. Again, everyone’s exact tax profile and financial journey will be different.

Instead focus on the takeaways:

• Paying tax on dividends or share gains can take a big chunk out of your returns.
• Most of us can and should use ISAs or pensions. We might be able to shield all our investments from tax, or at least postpone taxes until retirement. (Part of your pension withdrawals will almost certainly be liable for income tax eventually, niche scenarios aside.)
• Those with large sums invested outside of ISAs or SIPPs should read my articles on defusing capital gains and offsetting gains with losses to lessen the pain.
• Big into your cash hoard? At the time of writing gilts can be more tax-efficient investments for higher-rate taxpayers, as opposed to relying on cash ISAs. Switching up could free more ISA space up for assets such as equities or higher-yielding bonds.
• Think about the return on paying off your mortgage from a post-tax perspective. The ‘return’ of even cheap debt reduction may be higher than the taxed return from unsheltered cash.
• Are you maxing out your ISA allowance and yet you can’t or don’t want to put more into a pension? Then think hard about which assets you should really must shelter, versus those better able to withstand taxation. Capital gains tax, for example, isn’t due until you sell an asset and book the gain. You might be able to buy and hold some kinds of investments – properties, companies, investment trusts – and defer capital gains for decades. (Note that accumulation funds are liable for tax on their income though).

Pensions are more tax-efficient investment wrappers than ISAs

The core tax benefits of ISAs and pensions are theoretically the same. But pensions do have a few perks that make them slightly more attractive from a tax perspective – crucially the tax-free lump sum, and for higher-earners the likelihood of paying a lower tax rate in retirement – at the cost of restrictions on accessing your money.

For my part, I use a mix of ISAs and pensions. But I’ve begun to favour the latter with new money as I’ve inched closer to the age when you can access a private pension, and also as the old pension constraints were loosened.

A tax-efficient investment strategy is not too taxing

Hopefully you think this is all perfectly obvious and you already use ISAs and pensions yourself.

Subscribe to Monevator if you’ve not yet done so. You clearly belong here!

However I do sometimes still hear people saying they don’t need a tax shelter – often flagging small initial sums or extra admin hassle as justification.

This is wrong-headed. If you’re going to be a successful investor, you need a tax-efficient investment strategy from day one. It will benefit you many decades down the line!

Note: I’ve updated this article from 2012 to reflect our shining modernity in 2024. But the reader comments on Monevator have been retained, and may reflect out-of-date tax law. Check the comment dates if you’re confused.

What caught my eye this week.

Bad news! Not only are the machines now coming from our cushy brain-based desk jobs, but our best response will be to hug it out.

At least that’s one takeaway from a report in the Financial Times this week on what kinds of jobs have done well as workplaces have become ever more touchy-feely – and thus which will best survive any Artificial Intelligence takeover.

The FT article (no paywall) cites research showing that over the past 20 years:

…machines and global trade replaced rote tasks that could be coded and scripted, like punching holes in sheets of metal, routing telephone calls or transcribing doctor’s notes.

Work that was left catered to a narrow group of people with expertise and advanced training, such as doctors, software engineers or college professors, and armies of people who could do hands-on service work with little training, like manicurists, coffee baristas or bartenders.

This trend will continue as AI begins to climb the food chain. But the final outcome – as explored by the FT – remains an open question.

Will AI make our more mediocre workers more competent?

Or will it simply make more competent workers jobless?

Enter The Matrix

I’ve been including AI links in Weekend Reading for a couple of years now. Rarely to any comment from readers!

Yet I continue to feature them because – like the environmental issues – I think AI is sure to be pivotal in how our future prosperity plays out. For good or ill, and potentially overwhelming our personal financial plans.

The rapid advance of AI since 2016 had been a little side-interest for me, which I discussed elsewhere on the Web and with nerdy friends in real-life.

I’d been an optimist, albeit I used to tease my chums that it’d soon do them out of a coding job (whilst also simultaneously being far too optimistic about the imminent arrival of self-driving cars.)

But the arrival of ChatGPT was a step-change. AI risks now looked existential. Both at the highest level – the Terminator scenario – and at the more prosaic end, where it might just do us all out of gainful employment.

True, as the AI researchers have basically told us (see The Atlantic link below) there’s not much we can do about it anyway.

The Large Language Models driving today’s advances in AI may cap out soon due to energy constraints, or they may be the seeds of a super-intelligence. But nobody can stop progress.

What we must all appreciate though is that something is happening.

It’s not hype. Or at least for sure the spending isn’t.

Ex Machina

Anyone who was around in the 1990s will remember how business suddenly got religion at the end of that decade about the Internet.

This is now happening with AI:

Source: TKer

And it’s not only talk, there’s massive spending behind it:

Source: TKer

I’ve been playing with a theory that one reason the so-called ‘hyper-scalers’ – basically the FAANGs that don’t make cars, so Amazon, Google, Facebook et al – and other US tech giants are so profitable despite their size, continued growth, and 2022-2023 layoffs, is because they have been first to deploy AI in force.

If that’s true it could be an ominous sign for workers – but positive for productivity and profit margins.

Recent results from Facebook (aka Meta) put hole in this thesis, however. The spending and investment is there. But management couldn’t point to much in the way of a return. Except perhaps the renewed lethality of its ad-targeting algorithms, despite Apple and Google having crimped the use of cookies.

Blade stunner

For now the one company we can be sure is making unbelievable profits from AI is the chipmaker Nvidia:

Source: Axios

Which further begs the question of whether far from being overvalued, the US tech giants are still must-owns as AI rolls out across the corporate world.

If so, the silver lining to their dominance in the indices is most passive investors have a chunky exposure to them anyway. Global tracker ETFs are now about two-thirds in US stocks. And the US indices are heavily tech-orientated.

But should active investors try to up that allocation still further?

In thinking about this, it’s hard not to return to where I started: the Dotcom boom. Which of course ended in a bust.

John Reckenthaler of Morningstar had a similar thought. And so he went back to see what happened to a Dotcom enthusiast who went-all in on that tech boom in 1999.

Not surprisingly given the tech market meltdown that began scarcely 12 months later, the long-term results are not pretty. Bad, in fact, if you didn’t happen to buy and hold Amazon, as it was one of the few Dotcoms that ultimately delivered the goods.

Without Amazon you lagged the market, though you did beat inflation.

And yet the Internet has ended up all around us. It really did change our world.

Thematic investing is hard!

I wouldn’t want to be without exposure to tech stocks, given how everything is up in the air. Better I own the robots than someone else if they’re really coming for my job.

But beware being too human in your over-enthusiasm when it comes to your portfolio.

The game has barely begun and we don’t yet know who will win or lose. The Dotcom crash taught us that, at least.

Have a great weekend!

[continue reading…]

The UK inflation rate is down to 2.3% in CPI terms. The RPI inflation measure has fallen to 3.3%. Either way, the pound has stopped losing purchasing power like a proverbial drunken sailor on shore leave. This end to our run-in with runaway inflation is to be welcomed – but maybe with a wistful sigh from those of us who enjoyed seeing our mortgage inflation hedge in action.

Popular culture spent much of the 2010s debating how to survive the zombie apocalypse.

But it was actually inflation that rose from the dead to cause chaos:

CPI measure, source: BBC

Nearly everything got more expensive. The government subsidised household energy bills just to keep the lights on!

Meanwhile the pace of the rise in interest rates due to this inflationary upsurge was shocking. In less than two years we went from nearly-free money to the official Bank Rate at 5.25% and a bond market rout.

Those who didn’t stress-test their mortgage have felt extra pain if they left it too late to get a cheap deal.

And those who retired into a terrible sequence of returns haven’t exactly been laughing, either.

When you really get down to it

We’re all potentially made poorer in real terms1 by inflation.

When £100 isn’t worth what it was three years ago, neither is £100,000 in your pension.

To have the equivalent spending power of £100,000 in January 2021, you’d today need £131,000.

Note on numbers: I’m old-fashioned and have used an ​RPI inflation calculator​ from Hargreaves Lansdown, which is based on ONS numbers. You might argue it’s better to use the CPI figure these days, especially given CPI is the measure watched by the Bank of England. To do this you can do your own sums using the BOE’s ​inflation calculator​. But without getting all conspiracy theory about it, I’m inclined to go with the higher measure of inflation (RPI) while we still have it.

In real terms, a typical UK private investor’s balanced portfolio is back to where it was in 2016, according to the consultants ARC:

Source: Trustnet

The benchmark here is ARC’s own ‘Steady Growth Private Client Index’, which it says is based on the most common risk profile run by discretionary managers. Something like an expensive-ish 60/40 portfolio I’d imagine. (The indices are proprietary and for clients only).

This Steady Growth Index has delivered a 4% real return since inception. But ARC calculates it must achieve an annual return of 7.3% above inflation for a decade, to get back to the real terms trend line.

Ouch! Come back money illusion, all is forgiven!

Still, it’s not all been bad news.

Crucially and as a direct result of the bond crash, expected returns from fixed income are now positive and arguably quite attractive. That augurs well for today’s retirees.

Wages have risen, too. As the cost-of-living crisis abates, most of us saving for retirement should be able to increase our pension contributions.

But make no mistake, inflation has done a number on your number. You’re probably going to need a bigger pot.

The mortgage inflation hedge

Coaxing my ambling donkey back around to the topic of today’s post, a key bit of good news for anyone with a lot of debt is that their debt is almost certainly no longer worth what it was a few years ago.

Specifically, if you had a big mortgage ten years ago, then you may well still have a pretty big mortgage in nominal terms today.

But in real terms, its value is much diminished.

Caveats abound, naturally.

If you took out a big debt at a very high interest rate and didn’t pay it off, then it may have snowballed into an even bigger debt – even after inflation. Something like carrying a credit card balance that charges a double-digit interest rate that’s never paid off would fit this bill.

If you’ve had to refinance at much higher rates, that’s bad too. (Commercial property owners, I’m looking at you.)

However for a very long time, residential mortgage rates have flirted barely above the inflation rate – and lately well below it.

This has made the real terms cost of carrying mortgage debt roughly zilch, thanks to the very same value-eroding force – inflation – that’s been melting your purchasing power elsewhere.

Golden years

This was exactly why I badly wanted a mortgage in the post-financial crisis years.

Not just to buy my own home, but for the ability of debt to hedge against inflation.

Back in 2013 in a post titled Can you afford NOT to have a big cheap mortgage? I wrote:

…anyone who thinks a mortgage is bad news when inflation is running high is wrong.

An affordable mortgage secured on a real asset – a house – is an excellent thing to have at times of high inflation.

In 2013 inflation was headed towards 3%, which was enough to prompt my article that year. But even after that inflation spike proved short-lived, interest rates and mortgage rates continued to fall.

My fellow citizens were getting richer on free money. Meanwhile as a saver without any debt to my name, I was at risk of seeing my net worth being – relatively-speaking – financially-repressed away.

Long story short, I was itchy to get a mortgage – which I eventually did – for its inflation-hedging reasons almost as much as to buy my own home.

Down with debt

Here’s how this mortgage inflation hedge bolsters your finances in real terms.

Real value of debt decreases: Inflation reduces the real value of debt. Even if the amount you owe stays the same in nominal terms. Over time your mortgage becomes worth less and it’s easier to pay off.

Asset appreciation: If you own a home, its value should rise with inflation over the long-term. (UK house prices have risen by more than 3% over inflation for many decades.) As the nominal value of your house and other assets goes up and the real value of your debt goes down, your real net worth grows.

Any mortgage offers these benefits versus inflation. But a fixed-rate mortgage is especially handy.

With a fixed-rate mortgage, your monthly payments remain constant over the mortgage term. That’s at least two years, often five years, and potentially ten years or more. (It’s for the life of the mortgage in the US.)

Even as inflation causes other prices, costs, and your wages to rise, your fixed-rate mortgage payments do not increase. This means in real terms the cost of your mortgage payments decreases as the value of money diminishes. Like this your mortgage becomes more affordable on a monthly basis.

Of course interest rates will likely rise in response to inflation. That puts upwards pressure on variable mortgage rates and makes remortgaging more expensive too. More on that in a moment.

Mortgages are not risk-free! But that doesn’t stop them being a hedge against inflation.

How the mortgage inflation hedge works in practice

Suppose you have a £300,000 repayment mortgage on a fixed interest rate of 3%. For simplicity’s sake we’ll assume you took out one of the new super-long term fixes, set to run for 30 years.

Your monthly payments will be £1,265. However if inflation averages 3% per year, the real value of this fixed payment will decrease. In 10 years, it would be just £941 in today’s money.

Meanwhile the value of your home will almost certainly increase, given enough time. The price could more than double in 24 years with just 3% annual appreciation due to inflation.

By then you’d have a £600,000 home and only £83,000 left on your mortgage – which will feel like about £41,000 in today’s terms. Your monthly payments in terms of today’s money would be barely £600.

Here’s one we made earlier

We can also consider the inflation spike of the past few years.

Inflation – per the RPI measure of the cost of goods and services – was 32% between January 2020 and April 2024.

Ignoring any repayments made to reduce the mortgage balance, a £300,000 debt in 2020 is worth around £227,000 in today’s money.

Inflation has effectively reduced the debt by £73,000 – in terms of 2020 money – for you.

Bluffer’s tip! Just in case you ever find yourself stuck in a lift with a professional economist, the technical term for this is ‘Inflation-Induced Debt Destruction’.

A slightly absurd example to make the point

If this feels difficult to get your head around, let’s imagine extreme inflation of 900%.

We’ll say you’ve bought a £100,000 home with a £50,000 mortgage, for a 50% loan to value ratio.

Let’s also assume your house price keeps up with inflation, and we’ll ignore any mortgage repayments.

Your £100,000 home is worth £1m after 900% inflation. Your £50,000 mortgage is still £50,000 but it’s real terms value is now just £5,000.

The real value of the mortgage debt has fallen to a tenth of its original nominal value, even as the nominal value of the asset secured against it ten-bagged. Your loan to value ratio is now just 5%, because the house price rose with inflation but the mortgage balance didn’t budge. You are now rich in home equity!

Played out over several decades, this is exactly how your grandparent’s semi-detached house that they bought in their early 30s made them a modest fortune.

Other things to think about

What would a Monevator article be without a bushel of yeah buts? (Besides about 1,000 words shorter…)

Interest rates: The efficacy of a mortgage as an inflation hedge depends on the interest rate environment. If you lock in a low fixed-rate just before a period of high inflation, you’ll benefit greatly. Take out a mortgage at a high rate when inflation is behaving itself and the benefits are less pronounced.

Variable-rate mortgages: With these, the interest rate on your loan will very probably increase during an inflationary spike. This can partly or totally negate the benefit of a mortgage as an inflation hedge.

The risk of remortgaging a fixed rate: As per the variable rate mortgage, only more of a tense psychological thriller with a shocking climax versus a variable rates’ slasher flic thrills. If you come off a cheap fixed rate deal and take out a much more expensive one, your debt pile is again growing more rapidly and costs more to service. And again your hedging is blunted. (Plus it feels awful.)

Not a perfect hedge: I’m using the term ‘hedge’ in a way that will annoy some purists. Inflation does reduce the value of debt in real terms immediately. But assets bought with a mortgage won’t simply rise in lockstep. House prices and stock markets wobble around in the short-term. Think long-term for the full benefits to play out.

It’s the economy, stupid: Some readers have been shaking their heads throughout this article. What about the risk of not being able to pay your mortgage? Or of losing your job? High inflation usually coincides with other economic disruption that could render the strategy moot. All true. You could sell your house in a pinch – but if house prices have crashed in the chaos it might not solve the problem.

Your house isn’t the whole story: A recurring theme of my posts about mortgages (for example) is all this stuff is fungible. You have secured a mortgage on your home, but if you have investments elsewhere, then they are effectively being funded by the mortgage (because you could sell them to pay down your mortgage instead). And these assets could go up due to inflation in their own right, too. That may offset the pain of, say, stagnant house prices or higher mortgage payments.

Remember, a mortgage is just a way of funding a house purchase. People conflate choosing to run a mortgage with ‘gambling on property’. But once you’ve bought your home, the value of that asset – your house – will fluctuate, independently of how you funded it. Through this lens you’re ‘betting’ on house prices, but that’s regardless of whether you have a mortgage or not. What matters with respect to risk and the mortgage is whether you can afford to make your payments. Read my post about my interest-only mortgage to unpick this further.

Rents rise with inflation, too: UK rents have soared along with inflation over the past couple of years. In fact 2023 saw a record 9% hike. Paying off your mortgage and owning your own home will protect you from rising housing costs due to inflation and higher interest rates, obviously. But avoiding home ownership altogether to rent instead will not.

Deflation: In a scenario where money gets more valuable every year, you don’t want to owe it to anybody. Consider getting rid of your mortgage ASAP if you believe deflation is going to stick around!

Waking up to the real world

Reading all this some of you may be thinking “no shit Sherlock”, as you roll your triple-levered pork belly futures into call options on GameStop to play the gamma of meme stock legend Roaring Kitty slowing down his rate of posting 1980’s callbacks on his reactivated social media account.

(Everyone else: it’s fine not to understand that sentence. It just means you’re well-balanced and normal).

It’s true that Monevator readers do bat high versus the general populace when it comes to this stuff.

But most normal citizens do not understand the beneficial impact of inflation on debt.

Earlier this year, The University of Chicago’s Booth School released: Households’ Response to the Wealth Effects of Inflation.

The paper found:

On average, households are well-informed about prevailing inflation and are concerned about its impact on their wealth; yet, while many households know about inflation eroding nominal assets, most are unaware of nominal-debt erosion.

Once they receive information on debt-erosion, households view nominal debt more positively and increase estimates of their real net wealth.

This isn’t just a matter of academic interest. The – um – interested academics found that decisions about spending and debt changed when households better understood the impact of inflation.

Admittedly the boffins looked at Germans. Fears about debt remain embedded in that national psyche. And muted house price growth and a strong rental sector mean Germans don’t grow up on a televisual diet of property porn.

Then again, the study looked at mostly better-educated Germans, a majority of whom had mortgages.

That barely a third realised how inflation benefits those with debts is telling – and a finding I’m sure would carry to the UK and beyond, too.

Mortgages, houses, and hedge rows

Summing up, having a sufficiently chunky mortgage can be an effective hedge against inflation because inflation reduces the real value of that debt.

What’s more, the money raised by the mortgage will typically be invested in assets that can go up with inflation, such as – duh – a house but also other real assets such shares.

The mortgage inflation hedge works best when interest rates are low relative to inflation.

And as always there are risks, particularly with variable-rate mortgages and the broader macro-economic backdrop.

Carrying a big interest-only mortgage was a good financial move for the past 15 years. What’s more, this looked very likely in advance, given how governments and Central Banks were behaving – though other outcomes were certainly possible.

We might have seen deflation, say, if we’d seen the 1930s-style playbook that some pundits now say should have been employed instead of Quantitative Easing, for instance. Or perhaps a global depression in an alternative-universe pandemic. Both would have been bad for debt holders.

So we should beware hubris, carefully size whatever risks we take, and avoid going all-in on anything.

A mortgage is not for everyone, but…

As we repeatedly stress on Monevator, one size never fits all.

Besides the financial issues, some people just hate the idea of having a mortgage. They don’t want a bank having a claim on their home or monthly mortgage payments stretching off to the far horizon.

Which is absolutely fair enough.

Paying off a mortgage will never be a bad financial move. Even if you’re rich, say, and all that zero-ing your mortgage balance does for you is help you sleep at night, that’s still worth a lot.

But by the same token not having a mortgage often won’t be the best financial decision, given its relatively low cost versus other productive uses for the money.

Running a mortgage has other benefits beyond enabling you to buy a house. And inflation-hedging is on that list for me!

1. Real terms means numbers after inflation is taken into account. [↩]