You shouldn’t be paying tax on your investments

Taxation is a hot topic. And particularly the question of tax avoidance.

To most people, it seems wrong that super-wealthy people can pay proportionately less tax than us, just because they’ve got clever accountants and lawyers.

Having said that, you don’t have to be a millionaire to start thinking about protecting your money from the taxman. And you don’t have to think that organising your money to pay less tax is slightly dodgy or disreputable either. 

In fact, the government encourages it!

With just a little bit of effort, you shouldn’t have to pay very much – if any – tax on your investments or savings at all.

We’ll explain how in a moment. But first, let’s look at the main types of tax that will affect you as a British investor.

Note: unless otherwise stated, any allowances mentioned in this piece refer to the 2012/13 tax year, which runs from 6 April 2012 to 5 April 2013.

The main taxes that affect investors

There are two main ways of making money from your investments. Firstly, you can sell an investment for more than you bought it. This is known as making a ‘capital gain’.

If you make more than £10,600 in capital gains this tax year, you’ll be liable to pay capital gains tax (CGT) at a rate of either 18% or 28%, depending on whether you are paying basic-rate or higher-rate tax.

The other way to make money from an investment, is to generate an income from it. A stock might pay a dividend. A bond will pay a coupon. A property will hopefully generate rent (we’ll look at all these terms later in the series, but you get the point).

Just like your wages, any income you earn is liable for income tax. For example, income from bonds will be taxed at your income-tax rate. Dividend income is different. Basic-rate taxpayers don’t have to pay any further tax on dividend income, but higher-rate taxpayers have to pay 25%.

Certain investments – including most UK-listed shares – are liable for stamp duty at varying rates. It’s not easy to avoid this, so for investment purposes it’s best considered as a transaction cost – we’ll cover these later in the series.

How to protect your investments from the taxman

As I mentioned last time, investing is inherently risky. So you should tip the odds in your favour at every chance you get. One way to do this is to keep your costs to a minimum.

So how do you avoid paying more income tax or CGT than you need to? There are two key ways to do this: you can invest through an Individual Savings Account (Isa) or you can use a pension.

However, there’s one critical thing to understand for now. You often hear people talk about ‘which Isa should I buy?’ or ‘I need to get myself a pension’.

But neither an Isa nor a pension are investments in themselves: they are just investment ‘wrappers’. You can imagine them as being like safes, into which you put your investments.

The investments that you put in these safes will have at least some protection from tax. But beyond that, the safes themselves have no impact on the performance of the actual investment inside them.

The good news is that between these two wrappers, you can shelter more than £60,000-worth a year of investments from tax. That’s more than enough for most people’s needs.

And if you consistently save more than that each year, you probably don’t need to be reading these articles – you can pay someone to read them for you.

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• This article is taken from our beginners’ guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here