Most people don’t realise how much tax they can save just by investing in liquid assets like stocks and bonds for the long term.
Below is an outline of how £1 million could be invested at what would very likely be an extremely low rate of tax. We’ll call it ‘pretty much tax free’. Not every idea will apply to every person but hopefully the exercise will show that there are lots of ways to invest for the long term in a very low tax way - which, all else equal, will lead to significantly greater wealth creation than routes that incur higher tax (like, say, investment properties...).
For the purpose of this exercise we will assume that we are working with a married couple with two children but anyone with wealth to invest should be able find something that applies to them.
The Easy Stuff
ISAs: each adult can put up to £20,000 per year in a ‘stocks and shares’ ISA. Total £40,000
Some adults can utilise a ‘Lifetime ISA’ for up to £4,000 per year, which the Government will top up by 20% (i.e. up to £1,000 per year per person). There are, however, restrictions on withdrawals from Lifetime ISAs (the most relevant is that the money cannot be withdrawn prior to age 60 without incurring a penalty).
Total invested tax-free via ISAs: £42,000
The Slightly More Complicated Stuff
Pensions: Quite how much one can contribute to their pension depends on their earnings in the current tax year as well as their earnings and pension contributions in the three previous tax years. The calculation can be complicated, especially for higher-earners, but the bottom line is that each adult can contribute up to £160,000 into their pension in the current tax year (big disclaimer: this figure can vary from £0 - £160,000). A typical higher-earning adult might have about £60,000 of availability in any given tax year but for the purposes of this exercise let’s assume both adults have the maximum available. Total £320,000.
It gets better… The Government will top this pension contribution up by 20% and any higher or additional rate taxpayers will receive additional tax back once they file their annual return. For simplicity, let’s assume that only the Government’s 20% ‘top up’ is included in our ‘tax free’ investment pot (we’ll come back to the additional 20% rebate that a 40% taxpayer would receive in a bit).
Total invested tax-free via pensions: £384,000
The Children’s Part
Up to £9,000 per year can be put into each child’s Junior ISA. Total £18,000
Up to £3,600 per year can be put into each child’s ‘Junior SIPP’, which is like a junior pension. The Government tops this up by 20%. Total £8,640
Total invested in children’s accounts: £26,640
Special Note: All of the above - the ISAs and pensions - accrue future investment gains and income tax-free. This tax-free compounding is hugely valuable.
There is no tax to pay when withdrawing from an ISA, but there is usually some tax to pay when money from a pension is withdrawn. However, families looking to pass wealth to future generations often only take out the 25% ‘tax-free’ portion of their pension and leave the remainder to future generations because pensions are not subject to inheritance tax.
The ‘Low Tax’ Part
Each person has an £12,300 annual capital gains allowance. This means that they can realise a profit on their taxable investments of £12,300 each year before any tax is due. Importantly, any gains in an ISA or pension do not count towards this total.
If we assume that a typical portfolio might have an annual capital gain of 5% per year - which is a perfectly reasonable assumption based on both past returns and future projected returns - then a ‘taxable’ portfolio valued at £246,000 would generate no capital gains tax (assuming that the capital gains were realised each year).
A portfolio of £246,000 might generate dividends each year of approximately £4,920 (note: global equities are currently paying a dividend of c. 2%, hence this figure). Each person has an annual dividend allowance of £2,000, meaning that only £2,920 of that dividend would be taxable. There may also be some tax to pay on interest income if any bonds funds are owned but let’s ignore this for now because a) not all interest income is taxable, b) bonds might make up a very small portion of the portfolio and c) if interest income is a big part of the portfolio then these investments can often be put into the ISA portion so that this tax is minimised.
So, in sum, a ‘taxable’ portfolio of £246,000 would generate a tax bill of roughly £1,100; or just 0.45% of the portfolio’s value. Not bad!
Total invested via very low tax ‘taxable’ investment accounts: £492,000
The sum of all of the above is £945,000 and the tax that would be paid is about £1,100 (equivalent to 0.12% of the total portfolio value).
Now we add on top the £64,000 ‘tax rebate’ that 40% taxpayers would get from making the aforementioned pension contributions - and we get to £1,009,000.
And that’s how to invest £1 million 'pretty much tax free'.
The Ongoing Part, a.k.a. The Gravy On This Whole Plan
The £28,400 of tax free annual gains and the c.£3,260 of after-tax dividends that are assumed in the above could be neatly re-invested in either ISAs and/or pensions in future tax years thus building up one’s tax-free portfolio on an ongoing basis. The power of tax-free compounding growth then becomes even more powerful.
A couple who did the above at the age of 40 and made no further contributions to their investments would have ISAs worth £1.46 million, pensions worth £1.48 million and their ‘low tax’ accounts worth £492,000 - for a total of £3.44 million. Which would still only be generating about £2,200 per year in tax, for an incredible tax rate of 0.06%.
Oh, and their kids would have about £50,000 in each of their names.
Frankly, it’s somewhat incredible that such a system exists but it does and for those fortunate enough to have the wealth to take advantage of it - without any complicated offshore schemes or anything like that - it is a great advantage indeed.
How we can help
We work with clients to achieve outcomes such as the one outlined above. We advise on both the structuring of the assets (e.g. ISA, pension, ‘general investment account’ or trust, etc) and manage the investments on behalf of our clients. Please get in touch if you think we might be able to help your investments grow over the long term in a tax efficient manner.
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