When tax is payable on investment income, the real returns that you, the investor, ultimately receive will be reduced. The higher the rate of tax, the lower the total return for the investor.
To encourage long-term investment, however, the government has carved out some major exemptions that allow you to shield returns from personal taxation by HM Revenue & Customs (HMRC).
One of the best known and most widely used of these is the Individual Savings Account, or ISA. The amount that you can invest through an ISA each year is limited though, potentially exposing gains made from investments kept outside of an ISA to tax.
What taxes are there?
The tax due on investment income will depend on your personal circumstances and the form of your assets – whether you invest in bonds, company shares or property, for instance. These are the main taxes for investors to consider.
If you own bonds issued by a government or company, either directly or through a fund holding, you should receive regular interest payments, or ‘coupons’, from the issuer.
This counts towards your savings income in the eyes of HMRC, and although it is taxable, there are a number of exemptions.
Basic rate taxpayers – earning up to £50,000 a year – can receive up to £1,000 in annual savings income free of tax, while higher rate taxpayers – earning between £50,001 and £150,000 – can earn up to £500 without tax. Those earning more than £150,000 get no tax-free allowance.
If you own shares in a company, either directly or through a fund holding, you may receive a proportion of the company’s earnings. These distributions of company profits to shareholders are called dividends.
This income is taxable, although you can receive up to £2,000 in dividends each tax year without having to pay any tax. You must pay tax on dividends received above £2,000 at a rate that depends on your total income, including any savings and dividends. This could result in landing in a different tax band from what was used to calculate income tax.
If you are a basic rate taxpayer, you will pay tax on these extra dividends at 7.5%. If you are a higher rate taxpayer – earning more than £50,000 overall in a year – you will pay tax at 32.5% and if you are an additional rate taxpayer – earning more than £150,000 – you will face a top rate of 38.1%.
Capital gains tax
If you make money by selling an asset for more than you initially paid for it, you realise a profit that is known as a ‘capital gain’. This capital gain (the sale price minus the purchase price) can be liable for tax.
In any given tax year, you can receive a certain amount of capital gains tax-free. This annual allowance is currently £12,000. Any capital gains made above this level are subject to tax, at a rate that depends on your total income.
If you are a basic rate taxpayer, you will pay tax on these extra capital gains at 10%. If you are a higher or additional rate taxpayer – earning more than £50,000 overall in a year – you will have to pay 20% on any capital gains above the £12,000 threshold.
Individual government bonds and qualifying corporate bonds – but not bond funds – are exempt from capital gains tax.
Please note that different rates apply for residential property.
Like buying a home, purchasing commercial property is taxable. The threshold for paying stamp duty on commercial buildings or land is £150,000. The next £100,000 is taxed at 2% and above £250,000 a rate of 5% is due.
You also pay stamp duty – at a rate of 0.5% – when you buy shares in a UK company.
You don’t have to pay stamp duty, however, when you buy shares in a fund - even if this fund is composed of investments in property and company shares.
The fund managers incur stamp duty when they buy any company shares or properties held within their fund. This tax will in effect be paid by fund investors, as transaction costs are typically taken directly from the fund or out of returns before they are distributed.
How ISAs work
One way to minimise the amount of tax that could be payable on your investment income is to make the most of your ISA allowance.
There are different types of ISA to save in different ways:
- Cash ISAs – for cash savings
- Stocks and shares ISAs – for investing in bonds, company shares, unit trusts/OEICs and investment funds
- ‘Innovative finance’ ISAs – for holding peer-to-peer loans
You can save money into one of each type of ISA in each tax year up to a government limit. In the 2020/2021 tax year, you can put a total of up to £20,000 into your ISAs. This can be spread across any of your accounts: for instance, you could save £5,000 in your cash ISA and £8,000 in your stocks and shares ISA. Any unused allowance cannot be rolled over to the next tax year, however.
Although you will have paid tax on money that you save into an ISA, any future returns that you receive will be exempt from personal tax. Interest on cash ISA savings will not be liable for income tax, and any investment income, dividends or capital gains on assets held within a stocks and shares ISA will also be enjoyed free of personal tax.
The value of investing in the markets through an ISA can be highest when you come to liquidate your investments, in part or in full, as all of your capital gains will be tax-free irrespective of earnings that you have at that time in your life.
By way of an example, let’s assume that an investor puts £5,000 in to her stocks and shares ISA at the start of each tax year for 20 years. Her net returns after charges are 3% a year, and she reinvests this amount. After 20 years, her portfolio will be worth £138,382 – a capital gain of £38,382.
Given that she invested within an ISA wrapper, she has total flexibility to access her investments as she pleases without having to worry about capital gains tax. If her portfolio was held outside an ISA, on the other hand, her tax bill could be as much as £5,275 if she needed to liquidate it all at the end of this period, had used her capital gains tax allowance elsewhere and was a higher rate taxpayer.
The power of long-term investing within an ISA can be particularly powerful when planning for your child’s financial future through a Junior ISA. These accounts can hold cash savings as well as stocks and shares, and all returns are free from personal tax when they are accessed – only from the age of 18. Up to £9,000 can be saved into a Junior ISA in the 2020/2021 tax year.
Investing as early as possible in the markets through a Junior ISA, with capital locked away for as long as 18 years, allows parents to take a very long-term approach. When children come to draw on their money, whether to help pay for their first home or for university, all capital gains will be tax-free.
Savers between the ages of 18 and 40 can also open a Lifetime ISA, specifically designed to encourage saving for retirement and first-time homebuyers.
Up to £4,000 a year can be saved into a Lifetime ISA until your 50th birthday, with a government bonus of £1 for every £4 saved. Contributions into a Lifetime ISA count towards your annual ISA allowance of £20,000.
The government top-up will only be paid if savings are used to buy a first home (up to the value of £450,000) or if accessed after your 60th birthday. If the savings are drawn before 60, the bonus will not be paid and a 5% charge will be levied.
When you're deciding how to invest, it's important to remember that ISA and Junior ISA tax rules may change in the future and their tax advantages depend on your individual circumstances. The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.