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Beginners' Guides

How to cut your tax bill

Play your cards right and you may never have to pay a penny of tax on any of your investments. Merryn Somerset Webb looks at tax wrappers.

Tax and how you should and should not avoid it is all over the news this week. Here, we will work on the assumption that you want to pay only the taxes you are obliged to pay and that, to the extent you can, you'd like to avoid paying the rest. There is good news for new investors on this front: play your cards right and you may never have to pay a penny of tax on any of your investments.That's because you will be holding all your investments inside an Isa (individual savings account) or a pension.

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There is a lot of confusion about exactly what both of these things are and how they work. But they are both actually remarkably simple as long as you remember that they are not investments in themselves but tax wrappers into which you can put all sorts of investments.

Self-storage for your investments

Think of an Isa or a pension like a self-storage space. When you hire one from a company such as Big Yellow, you buy a box from them. You then fill up the box with all the stuff you want to store for a few years and they look after it for a small fee until you need it again.

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An Isa or pension is pretty much the same. You buy the box your Isa or pension wrapper from a financial provider of some kind and then you fill it up with investments that cost up to the annual allowance every year (currently £15,240 for an Isa and between £10,000 and £40,000 for your pension, depending on your income). You aren't investing in an Isa, or in a pension.You are investing via an Isa or a pension.

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That done you should be about as tax-free as it is possible to get. Once your money is inside an Isa you will pay no tax on any capital gains or any income payments from the investments you make. You can also withdraw the money at any point with nothing to pay.

How pensions work

Pensions are less simple. You get a tax rebate when you pay money in (the money goes into a pension "gross") and once it is in the wrapper you pay no capital gains or dividend taxes on it as it grows. The catch (and there had to be one, right?) is that when you take the money out on retirement (or after the age of 55), you have to pay income tax on withdrawals. Given the fairly generous allowances here (the allowances on these two wrappers alone come to over £55,000 a head a year), the majority of people will have very little need to worry about paying taxes on their investments until they take their pensions on retirement which is nice.

Capital gains and dividends

What if you have more than £55,000 a year to play with? The first thing to say is, lucky you. The second is that even then you shouldn't find yourself with much in the way of a tax bill. The two things to think about are capital-gains tax and the tax on dividends. When you sell an asset, the difference between the price you paid for it and the price you sold it for is known as the capital gain (or loss). That is taxable (at 20% if you are a higher-rate taxpayer).

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However, it also comes with an annual allowance of £11,100: you only have to pay tax on gains greater than this. So if you have made money on something, you can sell in tranches over a period of years to keep your bill down. You can also offset losses on previous investments against gains.

On to dividends. Outside tax wrappers these are taxed at 7.5%, 32.5% and 38.1%, depending on the tax band your income falls into. But once again, there are allowances. You pay no tax on your first £5,000 of dividend income. Assume the yield on a portfolio is around 3% and that means you can hold an equity portfolio worth over £150,000 before you are liable for any tax on your dividend payments. Not bad is it?

Three other schemes to consider

There are three other tax-efficient schemes the government has on the go. First, venture capital trusts, funds that provide finance for small but (hopefully) expanding companies. Buy into one of these (once you have filled up your Isa and pension, of course) and you get an income-tax rebate and your dividends and capital gains tax-free. Next, enterprise investment schemes (EISs). These are investments in small, early-stage companies and as such are pretty risky. They do, however, offer you relief from income, capital gains, dividend and inheritance taxes. Finally, there are SEISs (seed EISs): investments in very early stage firms that are even more risky.

We are not suggesting that any but the most experienced investors look at EISs and SEISs. But our point is a simple one: at first glance it looks as if UK investors should shoulder a relatively high tax burden (CGT at 20% and dividend tax at up to 38.1%). But for most ordinary investors these tax rates are irrelevant you shouldn't ever have to pay them.

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