But there are legal ways to shelter your nest-egg from the Inland Revenue’s grasp by taking advantage of Individual Savings Accounts (ISAs). There is also a whole host of other options that will allow you to minimise the amount of tax you pay each year and, therefore, make the most of your savings.
Individual Savings Account
Individual allowances
Minimising capital gains tax
The Individual Savings Account (ISA) is simply a tax-free umbrella that enables you to legally shelter cash, shares and insurance from income tax and capital gains tax. The scheme was introduced by the government in April 1999 to replace the previous tax free savings vehicles – Peps and Tessas.
Unfortunately, by replacing the old regime, the government cut down on the tax breaks available to individual savers. Under the old rules investors could save up to £9,000 a year in Peps and £9,000 over five years in Tessas. Now, under ISAs, savers are limited to £7,000 a year.
The government has also decided to cut back the tax benefits even further by removing the 10% tax credit on dividends from 5 April 2004. But the tax shelter is still worth having, providing you invest for the long term.
There are three types of ISA – cash, insurance and equity ISAs. A cash ISA can be a simple deposit account or a cash unit trust while an insurance ISA can be used to shelter investment bonds, such as with profit bonds, issued by insurance companies. Equity ISAs cover a wide variety of stock market investments, including shares, funds and investment trusts.
Under the government’s rules you can shelter up to £7,000 of savings from tax every year under the ISA umbrella. You can apportion this allowance by either putting the whole amount in an equity ISA (known as a maxi-ISA) or split it between the three types, with a maximum of £3,000 in cash, £1,000 in insurance and £3,000 in the equity element. This is called a mini-ISA.
Once you have decided how to split your allowance, you cannot switch it later. You cannot, for example, move money from a cash ISA into the equity ISA, although you can, of course, switch the underlying investments you hold. You can, for example, switch from investing in Marks & Spencer shares to HSBC shares.
It is also important to remember that if you take out a maxi-ISA you can only have one plan manager a year. That means you cannot split your £7,000 allowance between one investment fund and another. There are, however, ways around this. You can, for example, buy funds through a fund supermarket where the supermarket acts as your plan manager and offers a wide range of funds to you.
Having one plan manager is not a problem for investors who want to shelter their shares as stockbrokers will buy any shares you instruct them to. There is also less of a problem for mini-ISA investors as the government allows you to put the cash, insurance and equity elements with different plan managers.
You should also remember that these allowances work on a ‘use it or lose it’ basis. Basically that means if you don’t use up your entire allowance by April 5th each year you will lose the part you haven’t used. It also makes sense to try to avoid taking any money out of your ISA as the government will not let you replace it at a later date.
Once you have made the most of your ISA allowance you will have to pay tax on the remainder of your investments. You need to do this every year by declaring any income you have earned and capital gains you have made on your Self Assessment form.
But there are other ways you can cut down on the amount of tax you pay. One easy way to do this is to make the most of your personal allowance.
Every taxpayer gets a personal allowance, which enables us to earn a few thousand pounds of income each year without paying tax. If your spouse does not have an income that exceeds the personal allowance you can put some of your investments in their name to minimise tax.
You can use a similar principle if one of you pays basic rate tax and the other pays higher rate tax. Simply switch some of your investments into your partner’s name so you pay higher rate tax on a smaller sum.
Capital Gains Tax (CGT) is the scourge of all investors. Basically, every time you sell an asset for a profit, you make a capital gain which is taxed at 40%, although this rate falls the longer you hold the investment.
Luckily everyone has an individual CGT allowance and if you have built up a big portfolio over a number of years it is sensible to make the most of this allowance every year. If, for example, some of the shares you have been holding have quadrupled in value, it might make sense to sell a portion of them each year to use up your CGT allowance.
You can also use your spouse’s allowance so if you have a big tax liability and they don’t it is worth considering switching some assets between you. Remember that if you have made a loss in any one year, you can carry this forward to future years to set against any gains.
If you do find you are paying tax on investment income or capital gains it is probably worth employing an accountant. It might cost you a few hundred pounds but if they can rearrange your investments to minimise tax, it is money well spent.