Many Monevator readers strive to shave tenths of a percent off the running costs [1] 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 [2] 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 [3] – 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 [4] by using ISAs and pensions as soon as we start investing, and by judiciously managing any unprotected capital gains and losses [5] every year.
We can also become knowledgeable about tax on dividends [6], 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 [7] 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 [8]).
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 [9], 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 [10] or pensions [11] 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 [12] should read my article on defusing capital gains [13] 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 [14]. Check the yield on your ETF or index fund, as they do vary quite a bit. Remember that Accumulation funds accrue tax [15], too).
The tax benefits of ISAs and pensions are theoretically the same [16], 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 [17]
Not too taxing
Hopefully you think this is all perfectly obvious and you already use ISAs and pensions yourself. Subscribe [18] 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 [18] to ensure you get it!
- Also note that you can hold AIM shares in a SIPP, but not in an ISA. [↩ [22]]