Keep your profits away from the taxman
It can be incredibly tough to make a decent return on your savings and investments these days - and when you do finally manage to turn a profit, the taxman will be poised to take his share of the proceeds.
The good news is you can prevent this happening - or at the very least, minimise the amount you have to hand over to HM Revenue & Customs - by taking advantage of some very effective, and completely legal, tax-efficient vehicles.
How is tax charged?
Let's start with understanding how tax is levied. The two principal forms of taxation you are likely to encounter are income tax and capital gains tax, although you might also want to consider the potential longer-term impact of inheritance tax.
We all have a personal allowance, which is the amount of income we can receive before paying income tax. The tax owed on amounts above that will depend on your overall income.
Everyone gets an annual tax-free allowance and this will generally be fine for most people.
How can I pay less tax?
The next question is how to reduce your tax burden. The good news is there are a number of totally legal solutions that enable you to keep hold of your money - without resorting to some of the morally questionable schemes that got the likes of comedian Jimmy Carr in the headlines.
The first port of call for anyone should be individual savings accounts, more commonly known as Isas. These were introduced back in 1999 to encourage more people to save, and they have proved hugely popular as any gains that are generated are free of both income and capital gains tax.
There are two types of Isa: cash Isas and stocks and shares Isas. Cash Isas, which are open to any UK residents over the age of 16, are tax-free savings accounts that are available from banks and building societies.
The main benefit of a cash Isa is you will earn interest in exactly the same way as with a standard savings account, but the taxman won't take a cut.
A pension is another extremely tax-efficient tool. Investments in a pension are taxed in exactly the same way as they are in an Isa - gains enjoyed on the likes of cash, property, bonds and equities are free of income and capital gains tax.
You also receive tax relief from the government as your money enters your pension.
On the downside, you cannot get access to your pension until you retire - at which point the first 25% can be taken, tax-free in cash, with the balance being subject to taxation, depending on the retirement income option chosen.
For example, husbands and wives - as well as civil partners - are taxed independently so each will have their own personal allowances. Therefore, if one partner has a different tax rate to the other it's worth considering moving assets to the lower taxpayer to reduce the overall tax burden.
Your estate might be liable for inheritance tax when you die. But there are lots of allowances around inheritance tax that can be utilised, including an annual gift allowance and gifts out of income. In addition, there are a number of very useful trust options for tax-planning purposes, in which one or more trustees are made legally responsible for holding assets.
Using trusts in conjunction with your savings and investments can make real sense to ensure the right person receives the money at the right time - but this is an extremely complicated area so you will need to seek professional advice.
The racier ways to avoid tax
Individuals with substantial tax bills to pay - and we are talking well into six figures - may want to consider venture capital trusts (VCTs) and enterprise investment schemes (EISs), which give income tax rebates on the amount invested. While a step too far for most investors given the risks in the underlying assets, they can sometimes have a role to play.
VCTs invest in entrepreneurial businesses at an early stage. This means the investment may be high risk and speculative in nature but can end up delivering some spectacular returns, which makes them appealing for those with plenty of spare cash.
EISs are similar to VCTs but arguably even riskier because your money will be invested in the shares of a single company rather than a fund.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.