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Choosing the right tax wrapper - as important as choosing good investments

By Mike Narouei, Content Producer at Boring Money

3 Sep, 2019

To make the most money from investments, you might spend ages choosing between funds, but how much do you think about the tax? Here's an eye-watering view on the difference tax-free allowances can make.

The chances are you’re paying more tax today than you were just a few years ago. The latest statistics from HMRC show that it pulled in an extra £11bn in income tax in 2018/19 alone. Unless you’re an oligarch that won’t all have come from your pocket, but it should at least focus your mind on the importance of tax when investing.

Investment platform AJ Bell crunched the numbers and found that UK citizens are paying almost 30% more in income tax than they did 10 years ago. Mostly this is through ‘stealth’ tax rises - the ones you barely notice. Tom Selby, senior analyst at the group said:

“A number of factors have contributed to rising income tax bills in recent years, including the slashing of the dividend allowance from £5,000 to £2,000 and tax bands either being frozen or rising at a slower rate than wages. Both of these have resulted in more people being dragged into the higher and additional-rate tax brackets over the last decade or so.”

Tax can be pernicious

If you squirrel money away in savings and investments (and let’s not forget, this is money on which you’ve already paid tax) and that money grows in value – either because you’ve invested it in something clever, or you’ve received dividends on it (also quite clever) - you are liable to pay tax on that growth or income.

This can be quite chunky. If you make £10,000 in dividends and are a 40% taxpayer, you will lose around £2,600 in tax. As such, it can be just as important to get the tax right as to get the investment right. There may be a marginal difference of 5% or 10% between the performance of one collective fund over another, but an investor could be losing 40% on the wrong tax decision.

Also, you may find that allowances magically fade away as you earn more money. As a basic rate taxpayer you get a personal savings allowance of £1,000 a year, but that dips to £500 by the time you move into the higher tax bracket, and disappears altogether if you’re paying tax at 45%.

Everyone gets a tax-free Dividend Allowance of £2,000 a year, but the tax you pay after this amount climbs quite sharply. Basic rate taxpayers are only paying 7.5%, but additional rate taxpayers are paying 38.1%. Ouch!

It is worth considering some basic tax rules when investing

Where possible, use a tax wrapper such as a pension or ISA. Both allow your investments to grow free of capital gains. Any income paid out is also free from tax. The allowances are generous - £20,000 per year for an ISA and up to £40,000 for a pension (depending on your salary).

Keep an eye on capital gains. Capital gains tax (CGT) is as low as it’s been for some time, but it will still take around one third of your investment. Particularly perilous are those assets that you’ve held for a long time – they can show significant gains and HMRC won’t give you any credit for how long you‘ve held them. You have a £12,000 allowance each year, so make the most of it.

Increase pension contributions when you move to a higher income tax band. Selby from AJ Bell suggests, “this is a sensible and legitimate way to reduce the amount of income tax you pay.” The pension contributions put you back down below the higher income band and reduces your tax bill.

Tax is, obviously, very boring. However, it can be expensive to neglect it. While complex tax avoidance schemes can be dismissed, it is always worth taking advantage of government-backed, well-established options such as pensions and ISAs. Without them, the tax collectors will continue doing their best to wring you dry.