Many Monevator readers rightly strive to shave tenths of a percent from the running cost [1] 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 [2] 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 [3] (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 [4] 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 [5].
If needed we can even judiciously manage our capital gains and losses [6] every year on unsheltered assets, and defuse gains [7] 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 [8], 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 [9]. 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 [10] 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 [11]).
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 [12].
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 [13].
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 [14] or pensions [15]. 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 [7] and offsetting [6] gains with losses to lessen the pain.
- Big into your cash hoard? At the time of writing gilts [16] 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 [17] from a post-tax perspective. The ‘return’ of even cheap debt [18] 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 [19] for decades. (Note that accumulation funds are liable for tax [20] 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 [21]. 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 [22].
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 [23] 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.