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
- Bond funds
- Individual bonds
- Income producing equities
- Foreign equities (arguable)
To see why this sequence is likely to suit your circumstances, let’s just quickly tee up the relevant tax rates:
|2019/20||Income tax||Dividend tax||Capital Gains Tax|
|Basic rate taxpayer||20%||7.5%||1o%|
|Higher rate taxpayer||40%||32.5%||20%|
|Additional rate taxpayer||45%||38.1%||20%|
(Note: These capital gains tax rates are for investments like shares. Capital gains on residential property other than your own home are taxed at 18% and 28% instead of 10% and 20%.)
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 2019/20 tax year.
- Information on the CGT rate for 2020/21 is currently unavailable.
- Interest is taxed at your usual income tax rate. Basic rate payers have a £1,000 personal savings allowance, 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.
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 exchange-traded product (ETP) doesn’t trumpet its reporting status on its factsheet then it probably falls foul.
It’s worth double-checking HMRC’s list of reporting funds. Many offshore funds / ETPs available to UK investors don’t qualify. Also, it is possible for a reporting fund to lose its special status.
However, as reader NaeClue reminds us in the comments to this article:
…it is no longer possible for retail investors to buy non-EU domiciled ETFs any more, even those that do have reporting status such as Vanguard US listed ETFs.
So saving withholding tax saving in a SIPP is no longer available unless you buy individual shares.
You may already hold non-EU domiciled ETFs from before the rules changed – for example, US-listed Vanguard ETFs. Monevator readers report brokers allowing them to retain such funds they already own, but not to buy new ones. So if you do, hopefully you hold them in a tax shelter already!
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 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 got a lot worse for UK investors in recent years, 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 usually defer a sale.
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.
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,