Investing involves the risk that your capital goes down as well as up; you may get back less than you invested. The commentary below is not intended as a recommendation for you to personally buy or sell any of the investments mentioned nor to take any investment action whatsoever. 

“Compounding is the eighth wonder of the world” – Albert Einstein (allegedly) 

“My life has been a product of compound interest. Nothing more. Nothing less. And nothing brilliant.”  – Warren Buffett

 

Most people are familiar with the concept of compound returns: gains on an investment are reinvested to generate their own additional gains over time, thus creating an accelerating cycle of growth.  

It is why a snowball gets exponentially bigger as it rolls down a hill and why it only takes 42 folds of a sheet of paper to reach the moon. 

It is also why an investment that returns 10% per year doubles after 7.2 years rather than the 10 years it would take if the returns were not re-invested. 

What gets in the way of compounding? Yes, withdrawing from an investment and/or spending the income. But that part is sometimes desirable: taking out money to fund one’s life or to make a gift is often the very point of having the investment.  

What else gets in the way of compounding? Taxes. And the investor often has a fair bit of control over when to incur those taxes.  

Deferring tax as long as possible allows compounding to work its magic to the greatest possible extent, with often huge implications for the after-tax investment return.  

The amount of potential savings really depends on individual circumstances, but a straightforward scenario for a £1 million account is a savings of £600,000 after 15 years*. In other words, an investment portfolio that is worth £600,000 more just because of more astute tax management.

*Get in touch if you want the precise math but, in short, this is using a pretty basic 1.75% drag per year. The impact for something like a mis-timed withdrawal of the ‘25% tax free’ amount from a pension would be far, far more.

What To Do About It

Here are some straightforward strategies to defer tax:  

Delaying withdrawal from a pension. Taking that ‘25% tax free’ unnecessarily early may just create a taxable investment account where a tax-free one previously existed. 

Thinking twice about taking a taxable withdrawal from a pension simply to make a gift. Even if it ultimately avoids Inheritance Tax by ‘gifting out of excess income’, the tax is paid immediately rather than in the future. 

Buy and hold. Don’t sell something (taxable) unless you have to. You, therefore, delay the capital gain. This strategy is usually made easier if you own funds rather than individual equities, and even easier if you own some index funds that simply track the global stock market because you can build an ‘active’ portfolio around the large, ‘passive’ and more tax-efficient building blocks. 

Nominate grandchildren as pension beneficiaries. Private pensions are really just trusts. For families that can afford to do so, moving these trusts into the youngest peoples’ names upon death of the oldest generation can be a highly useful tax deferral strategy. 

Use profits from an operating company to create a Family Investment Company. This one is more niche and complicated, but the point is the same: don’t pay (as much) tax until you need/want to spend the money.  

 

We often get asked how we justify our industry’s relatively high fees. For many, the answer is simply behavioural: people act more intelligently with their money when a professional is holding them to account. But we often save our clients a lot of tax too.