They say that there are two guarantees in life, the first being death and the second being the obligation to pay taxes.
As you may have already thought, paying tax is a key responsibility when it comes to investing.
Even if you invest with small amounts of money, over time you tax liabilities may become larger and larger as your money compounds.
Unless you are paying for an accountant to deal with your tax liabilities, you will be responsible for dealing with all of the taxes that you are required to pay.
Tax avoidance is a criminal offence that can come with a prison sentence in some cases.
With that said, many small investor may not pay any tax at all, or the tax payments may be dealt with by your broker in some cases.
To pay tax on investments in the UK, investors are required to report their earnings to HMRC via the self assessment platform.
Below are a set of taxes that you have to be aware of as an investor.
Arguably the most widely recognised tax when it comes to investing is capital gains tax.
The concept is pretty simple. When you buy a stock and sell it for a profit, an investor is liable to pay tax on that profit.
For example, if an investor buys a stock for $10 and sell it for $25, $15 would be subject to capital gains tax.
You simply subtract the original investment from the price of the investment when you sold it.
In the UK, investors are only required to pay capital gains tax after they make over £12,300 in a single year. This allowance does not apply to individuals with an annual income above £100,000.
Capital gain tax rates in the UK are currently 20% for higher rate taxpayers (income above £37,000 after the personal allowance) and 10% for basic rate taxpayers (income up to £37,000 after the personal allowance).
So, if an investor had an income of £30,000 and had invested £50,000, buying and selling stock with a profit of £15,000, they would be liable to pay some capital gains tax.
The investor in this scenario would need to subtract their capital gains tax allowance from their profit (£15,000 – £12,300), which would be £2,700.
The investor would then pay capital gains tax on that £2,700, either 10% or 20%. In order to work out if the investor needs to pay 10% or 20%, it’s necessary to assess whether they are a basic tax payer or a higher rate tax payer.
To do that, you simply add the amount liable to capital gains tax (£2,700) to the individuals income (£30,000), which in this case would be £32,700.
As a consequence, we can see that this investor is a basic rate tax payer and so they need to pay capital gains tax of 10%.
So you simply need to calculate what 10% of £2,700 is – which is obviously £270.
The investor in this scenario would pay £270 in capital gains tax, keeping £14,730 of their profit.
When you receive a dividend, you may or may not have to pay tax on it. This is because in the UK, there is a tax-free dividend allowance of £2,000.
So, if you receive dividends that are less than £2,000 in value, you will not pay any tax at all.
For context, if we say that dividend paying stocks pay a 3% dividend, you’d have to invest around £67,000 to receive dividend payments in the region of £2000 a year.
The reality is, most investors will not only hold dividend stocks, unless they are specifically investing for income.
Anyway, the tax rate that you pay on your dividends depends upon the tax rate that you are in, just like with capital gains tax. Basic rate taxpayers are liable to pay 7.5% in dividend tax, higher rate taxpayers pay 32.5% and additional rate taxpayers pay 38.1%.
Much like with capital gains tax, it figure out what tax bracket you are in, you need to add your dividend income with your ordinary income along with any capital gains.
So, if an investor had £3,000 in dividend payments, with £30,000 from their job, their total income would be £33,000.
when you take the personal allowance of £12,500 away from this income, you are left with £20,500 – which makes this individual a basic rate taxpayer.
This individual would pay 20% income tax on £17,500, no tax on £2,000 worth of their dividend income because of their dividend tax allowance and 7.5% on £1,000 of the dividend income (the income above the dividend allowance).
Therefore, this individual would pay just £75 in dividend tax, alongside their income tax liability of £3,500.
As a consequence, the investor would pay £3,575 in tax, keeping £29,425 of their income. Obviously, this figure does not account for national insurance obligations.
When you invest in UK-based companies via the London Stock Exchange, you will be liable to pay Stamp Duty Reserve Tax.
The good news is that your broker is usually responsible for collecting this tax payment, as it is paid when you buy stocks.
You only pay Stamp Duty when you buy a stock with £1,000 or more. So, if you invest with less than £1,000, you won’t pay any Stamp Duty at all.
The rate that investors pay in Stamp Duty is 0.5%, which may not seem like a lot but it does represent another cost of investing.
For example, if you invested £2,000, you’d pay £10 in Stamp Duty and £10 to the broker for the transaction. Therefore, you’d start in a -1% position.
If you invest overseas, you do not have to pay Stamp Duty at all, you equally don’t have to pay Stamp Duty if you are investing in most funds, are given stocks for free or are subscribed to a new issue of shares in a company.
Paying tax is a controversial issue, whereby big companies are lambasted in the media for not paying any tax at all.
Tax efficient investing is not necessarily about paying as little tax as possible, it’s more so about paying tax when you are supposed to.
The government have created a number of different investment accounts that carry tax benefits, in order to encourage individuals to save more money or to help people prepare for their retirement.
ISA’s are probably the most well known type of account, where people can save money without paying tax on the interest earned.
Individuals may or may not be aware that there are investment ISA’s too, where investors can make investments (up to the value of £20,000) without paying any tax on capital gains or dividend income.
ISA’s allow ordinary individuals to pay no tax at all, while being able to invest significantly large sums of money. As a result, investment ISA’s are consider tax efficient.
Another tax efficient investment account is called the Self Invested Personal Pension (SIPP). As the name might suggested, this is when investors make investments on their own behalf for their pensions.
When individuals invest in a SIPP, they do not pay tax on income or capital gains, just like with an investment ISA.
The issue with the SIPP is that you are not allowed to withdraw money from it (in most cases) until you reach the age of 55.
This is obviously a big disadvantage if something goes wrong in life and you are desperate for cash.
With both the investment ISA and the SIPP, you have to be wary of the rules and charges that are associated with your account. Each provider has different rules, so it’s important to be fully informed before making any decisions.
The alternative to tax wrappers is to just use an ordinary dealing account, which will obviously be subject to all of the associated investment taxes.
The way to make an ordinary dealing account tax efficient is to have a buy and hold strategy that means that you never really sell any stocks. That way you won’t pay any capital gains tax.
At the same time, if you invest in stocks that do not pay a dividend, you will not pay dividend tax. If you invest in foreign stock markets (like the USA), you also won’t pay Stamp Duty.
This way, you’d only pay capital gains tax when you sell all of your stocks later on.
For example, imagine that you invested £300 a month from the age of 30 and wanted to withdraw your investments at the age of 60.
If you were able to maintain a return of 15% a year on average across that timeframe, you’d theoretically end up with £1,565,082.53 and would pay roughly £310,000 in capital gains tax (assuming that rules stay the same).
Many investors may feel that the capital gains tax liability is worthwhile for the amount of growth that they experienced over the course of the 30 years.
Of course, you could do the same thing with a SIPP or investment ISA and not pay any capital gains tax, this option is more so for investors that want to invest without any limitations or rules on their account.
For instance, if you did the same thing from the age of 20 to the age of 50, you wouldn’t be able to withdraw any of the money until you were 55. You’d essentially be a millionaire but you wouldn’t be able to utilise any of the money.
In reality, it’s all about picking a type of account that suits you. For tax efficiency purposes though, investment ISA’s and SIPPs are the best choices for most investors.