Most investors would rather think about where their next ten-bagger is coming from than worry about their tax return. But it's worth taking the time to make sure you are investing as tax-efficiently as possible. It could save you a fortune in the long run.
Taxes to watch out for
Investments attract several types of tax. First is income tax, charged on interest and dividends. Due to a change made by Gordon Brown when he was chancellor, you suffer the first 10% of income tax on dividends come what may. But the rest you can do something about.
Next there's capital gains tax. This is the tax on any profits you make from selling 'chargeable assets'. These include second homes, shares, most bonds and even derivatives such as futures and options. Then there's stamp duty the registration tax paid by a buyer of property (the rate varies according to the price paid) and shares (0.5%). Finally, there's inheritance tax on assets left behind after you die. That's a lot of ways for HM Revenue & Customs to clobber you. So how do you fight back? Here are four tips to help you hang on to your profits.
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1. Use your Isa allowance
This is the most obvious tax-saving move. You get a tax-free allowance each year that can be split between cash and shares. The limit is currently £7,200 for the under-50s, or £10,200 if you're 50 or above (it rises to £10,200 for everyone from 6 April). This allowance must be used by 5 April 2010, or you lose it. Half can be put in a cash Isa. The rest can be used to buy shares.
The beauty of Isas is that once you've bought shares, any dividends are received tax free (beyond the 10% mentioned above). Capital gains are also tax free. But once you are fully invested up to the annual limit, should you then sell the shares held in an Isa, you can't change your mind later and reinvest in the same Isa. Your previous tax protection is gone for good. But unlike a personal pension that locks you in until you retire, you can get at your Isa funds anytime.
There are two ways to set up an Isa. You can drip-feed in a regular monthly amount, usually the best bet in terms of managing your cash flow. Or you can play catch-up later in the tax year with a lump sum investment before 5 April. This route relies on you getting your market timing right so, while better than doing nothing, it's not ideal. Finally, couples: you each have an Isa allowance, so if one partner is wealthier it's worth splitting assets between you to take advantage of both allowances.
2. Use your capital gains tax allowance
Capital gains tax (CGT) has two bonus features compared to income tax. First, the rate is a flat 18%. Second, you get the first £10,100 of any gains tax-free. But there's a catch. To claim this 'use it or lose it' benefit, you have to sell a chargeable asset, such as shares, within the tax year. Otherwise there's no cash gain to protect. And watch out you can no longer create one by just selling shares before the end of the tax year, then buying them back straight afterwards. That's called 'bed and breakfasting' and has been barred by the share matching rules applied by HMRC.
These rules dictate how you match up sales and purchases of shares to work out the overall gain. You start with same-day purchases so buy 1,000 shares in the morning and sell them in the afternoon and the gain will be your proceeds minus whatever you paid. But if you sell shares having made no same-day purchases, the '30-day rule' kicks in. You match sales proceeds against the cost of any shares you buy in the 30 days after the sale date. In short, this rule forces you to wait 30 days to buy back shares you've already sold if you want the gain to count for CGT purposes. That's a long time in a volatile market.
An alternative is "bed and spousing", says Mike Warburton at Grant Thornton. A husband can sell shares and his wife buy them straight after. This way you could use up both CGT allowances. However, this must be by way of a proper sale, not just a transfer of assets. If 'bed and spousing' isn't an option, then start thinking now about which shares you'll sell. Finally, if you sell shares at a loss, don't forget to keep a note. You can carry forward capital losses indefinitely and use them to reduce future gains without eating into your £10,100 exemption.
3. Don't ask for share certificates
Share certificates are no longer a record of legal ownership (which is captured on an electronic share register). So why bother? If you want share certificates then the 0.5% stamp duty charge is rounded up to the nearest £5. On an electronic transfer, it's rounded up to the nearest penny. Besides, certificates are just more pieces of paper to manage.
4. Give your assets away
If you die holding a portfolio of shares it counts as part of your death estate and can be hit for 40% inheritance tax (IHT). But as well as the exemption that covers the first £325,000 of a death estate (or £650,000 for a couple), there's another way to get around this tax give assets away. Gifts to certain people, such as your spouse, are tax-free anyway. So is a single gift to anyone each year of up to £3,000.
However, be aware of the 'potentially exempt transfer' (PET)rule. You can give away any amount to anybody as a PET, but you must survive at least seven years after making any gift, or IHT is levied on the recipient. Always seek tax advice on gifts, as although an outright gift will usually escape IHT, any 'chargeable disposal' (a term that covers gifts and sales) can trigger a capital gains tax bill for the donor.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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