Welcome to the September 2017 newsletter from Chamberlains
Another fairly brief note this month – but with an important subject: Investments and tax implications.
In the last few months I’ve written quite a bit about Inheritance Tax but how do you get something to leave to the next generation?
A good friend of mine, Barry Davys, an IFA in Barcelona, has written a piece on “Why to Invest”. I wrote to tell him it was one of the best explanations of why it’s important to invest that I’d read in a long time and he kindly gave me permission to reference it here. Take a moment to read it and then I will highlight why I think it’s so relevant…
The main reason it’s good to invest rather than to accumulate money in a bank account is because interest rates are so low (and likely to stay so) and investments have always done so well over a reasonable period. Even when interest rates were higher, cash savings were only keeping pace with inflation – so in real terms the balance was only growing by your extra savings.
Barry provides two illustrations to compare cash savings with a mixture of investments. At current rates, a bank balance of £100,000 now would reach £109,369 in 2026, whereas a similar investment in a balanced portfolio would reach £221,935, based on actual performance in the last 25 years. If these same amounts were left another 25 years until 2061, they’d reach £153,398 and £1,511,532! (He uses euros, but it’s the same story with pounds.)
It’s very convincing, and he gives a number of reasons – technical advances etc. – to think positively about future gains in investments. You might say, “Well he’s bound to say that – he’s trying to persuade us to invest through him” but that doesn’t mean it’s not true! Of course, everyone’s circumstances and attitude to risk are different, and that’s why it’s so important to have tailor-made solutions. I can only offer general views on these matters – a properly qualified IFA can help with specifics. [I can give details of possible IFAs rather nearer to hand than Barry.]
BUT TAX IS ANOTHER MATTER…
And here I can be more helpful. But the government has also been helpful. They like us to invest in business rather than just in the banks – a) it’s good for the economy and b) they’re less likely to have to help us survive an impoverished old age. There are a number of incentives, notably ISAs (“Individual Savings Accounts”) and Pensions. Both these “wrappers” give tax-free environments for investments to grow, ie. there’s no tax on interest or dividends and no capital gains tax on sale of investments.
Pension funds are less accessible than ISAs (although they’ve become more so) but they have the big advantage of a boost from the taxman. If you put £80 into a pension, HMRC adds another £20. And if you’re a higher rate taxpayer you get back another £20 via your tax return, so that the £100 in your pension pot will only have cost you £60. Even if you’re worried about the ups and downs of investments, this gives a good buffer against the downside.
There are limits as to what you can invest in either ISAs or Pensions, but they’re quite generous and they don’t limit most of us. The annual allowance for ISAs is now £20,000, and you can put another £4,128 into a “Junior ISA” for any child. The allowance is on a year-by-year basis, so you “use it or lose it”. There’s also a “Lifetime ISA” as from last April. You can invest up to £4,000 each year and the Government add a 25% bonus to anything you pay in up to age 50. You can use the money to either buy your first home or to fund your retirement once you reach age 60. You can make withdrawals for other reasons, but only in emergencies because you lose your bonus and you’ll pay a 5% fee on anything you take out.
The headline annual limit for pensions is £40,000, but it’s quite complicated. It depends on your earnings and on whether you’ve fully used it in the past – you can bring forward unused allowances from the last three years. If you don’t have any earnings, you can still invest up to £2,880, which HMRC will top up to £3,600.
OUTSIDE THE WRAPPERS…
Life is not quite so easy for investments, but they still do well. I’ve talked about tax-free interest – £1,000 each year, or £500 if you’re a higher rate taxpayer, but here we’re more concerned with “proper” investments. And even here, the tax environment is attractive. This current year you can receive up to £5,000 dividends tax-free, after which you pay 7.5%, or 32.5% if you’re a higher rate taxpayer. (This is planned to reduce to £2,000 from April 2018.)
However, your investment advisor can point you towards investments which don’t pay dividends – they simply plough back their profits and the shares become more valuable. (This has always been the favoured route of Warren Buffett, the legendary US investor.) If you need the income, you can always sell part of the investment. This sort of thinking is called “Absolute Return on investments” – it’s the same whether your £100 pays you £5 dividends or whether it simply increases in value to £105.
Except that it’s different for tax. The £5 dividends are subject to income tax (after the initial £5,000) whereas the £5 increase in value is a capital gain if you sell the investment. But capital gains are fine – you get a tax-free £11,300 this year and CGT is lower than income tax. If the gain falls within your basic rate band you only pay tax at 10%; higher rate taxpayers pay 20% – both only half the normal rates of income tax. In other words, even outside the wonderful world of ISAs and Pensions, growth investments are very attractive.
There are further incentives to invest in riskier types of shares. Last month I talked about the IHT advantage of AIM shares (some fund managers have strong offerings to cater for this), and there can be more immediate savings in EIS investments. But that’s for another time…