Income Tax and Capital Gains Tax can cause a real dent in investment returns. Discover seven ways to reduce tax on your investment income.
Benjamin Franklin once wrote that “Nothing in the world is certain, except death and taxes”. Although you can’t defy death, there are ways to reduce tax on your investment income.
From investing in ISAs and pensions to magnifying your allowances, you can ensure more money is going towards your financial goals and less to the taxman.
Read on to discover seven ways to create tax-efficient income.
1. Use ISAs and pensions
You don’t pay tax on interest or dividends in an ISA or Capital Gains Tax on profits.
There’s a yearly limit on how much you can invest in ISAs, which is set to £20,000 for the 2020/21 tax year. You can withdraw money whenever you like without paying tax.
Money inside a pension is exempt from tax, plus you’ll receive 20% tax relief on payments. When you draw income from your pension after the age of 55, the first 25% is tax-free and the remainder is then taxed at your marginal Income Tax rate. Higher-rate taxpayers should withdraw income from ISAs before pensions.
The maximum amount you can invest in pensions each year while receiving tax relief is 100% of your salary, up to the Annual Allowance of £40,000.
These allowances are per person, so couples have a £40,000 ISA allowance. Meanwhile, this is up to an £80,000 pension allowance if your spouse is in a lower tax bracket, so enhancing their pension helps you to pay less tax on any investment income.
2. Reduce your income
In the 2020/21 tax year, the Personal Allowance enables you to earn £12,500 in income without paying tax. This applies to your salary, savings interest, and income from investments.
If your income exceeds £100,000, your Personal Allowance reduces by £1 for every £2 of income and the allowance is zero if your income is £125,000 or higher.
Pension payments can restore your Personal Allowance. If your income is £105,000, you could pay £5,000 to your pension and reduce your income to the threshold.
You could preserve your Personal Allowance by giving money to charity, transferring income-producing investments to your spouse, or by investing in ISAs.
3. Maximise the Dividend Allowance
The Dividend Allowance allows you to earn £2,000 in dividends without paying Dividend Tax. If dividends are your only source of income, you can generate £14,500 in tax-free investment income each year, made up of the £12,500 Personal Allowance plus a £2,000 Dividend Allowance.
For dividends above £2,000, basic-rate taxpayers pay 7.5% tax, higher-rate taxpayers pay 32.5%, and additional-rate taxpayers pay 38.1%.
Remember, you don’t pay tax on dividends within an ISA.
4. Don’t forget the Personal Savings Allowance
Basic-rate and higher-rate taxpayers have a Personal Savings Allowance of £1,000 and £500, respectively. This is the amount of interest on cash savings and fixed interest investments you can earn each year without paying Income Tax.
Interest rates on savings are low, so you’d need about £100,000 in non-ISA savings before you need to worry about tax on interest.
5. Use your Capital Gains Tax allowance
The Capital Gains Tax allowance is the amount of tax-free profit you can make from selling assets. In the 2020/21 tax year, it is £12,300.
If you make gains above £12,300, basic-rate taxpayers pay 10% Capital Gains Tax, while higher-rate and additional-rate taxpayers pay 20% Capital Gains Tax. For residential property, it is 18% and 28%.
You can’t carry forward your allowance to future tax years. If you’re planning on making a series of asset disposals, you might want to time the sales to use up as many annual allowances as you can.
It’s possible to transfer assets to your spouse tax-free. You can double your allowance to £24,600 and if your spouse is in a lower tax bracket, you can pay Capital Gains Tax at a lower rate.
Any unused capital losses can be used to offset future capital gains. Once claimed, capital losses are carried forward indefinitely.
Investments held inside an ISA don’t attract Capital Gains Tax.
6. Consider investing in investment bonds
Investment bonds enable you to withdraw up to 5% of the amount you’ve invested each year without paying any immediate tax. This allowance is cumulative, meaning you can carry forward unused parts of the 5% limit to future years. If you withdraw more than your cumulative allowance, you may have to pay Income Tax.
7. Don’t let tax dictate your decisions
Reducing tax can be an effective way to maximise your income from investments.
Tax shouldn’t be the deciding factor when choosing investments. The best way is to invest intelligently, build a healthy well-balanced portfolio, and give your money the time to grow in the long term.
After all, growing your money and paying taxes is likely to put you in a better position than if you pay zero tax but suffer losses.
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