Most of us are familiar with paying Income Tax on our earnings from employment, But do you know how your investments impact your tax free allowance, can impact whether you pay basic rate tax and change your UK tax brackets?
Most types of investment income are also subject to Income Tax, such as the interest received on savings, and any money received from share dividends. Investments made for capital growth also have tax implications – any gain, or profit, may also be subject to Capital Gains Tax.
Not all investment income is taxed at the same rate; there are specific rules, entitlements and exemptions that you need to be aware of if you’re planning to invest. There are also a number of investment options that are tax-free, offering a tax-efficient way of investing.
Here’s a list of investment income that is liable for tax:
1. Interest from most savings.
2. Income from a pension.
3. Rental income.
4. Dividends from shares.
5. Capital gain from the sale of shares or property.
Tax bands and income tax brackets
You are allowed to earn a certain amount of money tax-free, known as your tax free allowance, and for the 2013/14 tax year this amount is usually £9,440 for those under 65, although those 65 and over are entitled to enhanced personal allowances. Beyond this threshold you will start to pay tax.
Any money that you ‘earn’ from your investments will be taxed at the highest UK tax brackets applicable to you – it is, in effect, added to your other income and then taxed.
In summary, for the 2013/14 tax year, beyond your personal allowance you will pay income tax on any income from employment, savings, pension or rent as follows:
- You pay 20% basic rate tax for any income between your personal allowance and £32,010
- You pay 40% for any income above £32,011
- You pay 45% for any income above £150,000
Income tax is progressive, the higher your income the more tax you pay.
If an investment gives you an income, rather than capital growth (this is any increase in the original amount you invested, after costs, charges and depreciation) then the Income Tax rules apply, so drawing your pension (through an annuity or other similar product) will be taxed at your rate of Income Tax. Rental income from ‘residential’ property letting – the profit from your rental property after allowable deductions – will also be taxed in this way.
A dividend is a part of the company’s profits that is given to shareholders – the dividend is calculated per share, so the more shares you own, the more money you get. Dividends attract Income Tax.
- If you are a basic rate taxpayer, you pay the dividend ordinary rate of tax – 10%
- If you are a higher rate taxpayer, you pay the dividend upper rate – 32.5%
- If you are a additional rate taxpayer, you pay the dividend additional rate of 37.5%
Dividends you receive from your shares carry a 10% tax credit. The tax credit is the amount of tax paid by the issuing company on the shareholder’s behalf – you receive your dividend net of this amount. This means if you’re only liable for the ordinary rate of tax on dividends, you have no further tax to pay – the 10% tax credit (already paid) cancels out the 10% ‘dividend ordinary rate’. However, if you’re a higher rate taxpayer you have a total liability of 32.5% on dividend income – the tax credit reduces this to 22.5%, and this is payable when a personal tax return is completed. The same applies to the additional rate – the tax credit reduces the 37.5% by 10%.
An exception to these tax rules is dividends from ISAs (including ISAs which were previously PEPs) which are tax-free.
Capital Gains Tax (CGT)
If you dispose of an asset for more money than you bought it for, you’re said to have made a capital gain, or in more familiar terms, a profit. The gain you make, i.e. the profit – not the amount of money you receive for the asset – is liable for tax at a rate of 18% (up to £35,000), or 28% for higher rate tax payers. (from £35,001)
Before any tax is payable though, you have an annual tax-free allowance for Capital Gains Tax (CGT) known as the ‘Annual Exempt Amount’, and this amount is £10,600 for the 2011/12 tax year. There are also many reliefs and exemptions available, which can reduce or completely wipe out any CGT bill.
There are a number of assets that are not subject to Capital Gains Tax, for example, you do not pay any CGT when you sell your main home, irrespective of the profit made. Capital Gains Tax may apply to the sale of property/assets bought as an investment, and to the disposal of some stocks and shares.
How is the tax on investments paid?
Some tax on investment income is taken at source and other tax is payable when you file your tax return. The way you pay tax on your investment income depends on your tax band and on the type of investment in question.
The tax payable on the interest on savings and on dividends is normally deducted at source in line with the basic rate of tax. In other words, the tax is ‘withheld’ and is taken from any interest or dividend payouts before the money hits your account. If you are a basic rate taxpayer you have no further tax liability, however, if you are a higher rate tax payer then additional tax will be payable when a personal tax return is completed. However, it is important to bear in mind that some investments have the income/interest payable without deduction of tax although it is in fact taxable and will be up to you to account for it in your tax return.
Financial institutions will send you a tax certificate shortly after the end of the tax year, and companies will send out dividend vouchers when dividends are issued, so you can keep a record of the money you receive for tax purposes. You need to keep these documents for six years.
In the case of Capital Gains Tax, this is only be payable once your tax return has been submitted and your tax liability has been calculated by your tax adviser or HM Revenue & Customs (HMRC).
It’s important to make provision for your tax bill when you receive money from investments.
Tax wrappers: tax-efficient investments
To encourage people to save and to make provision for their future, the government allows certain “wrapper” products that hold investments in a tax efficient wrapper – they are free of Income Tax and Capital Gains Tax. These include ISAs, Child Trust Funds and pensions.
A tax wrapper (such as an ISA or pension) can be wrapped around either the underlying investment or the pooled investment, and means you pay less or no tax.
ISAs and tax - As long as you keep the investments within an ISA you are not liable to pay any Income Tax or Capital Gains Tax on the growth of the investments. There are, however, limits on the amount you can invest in an ISA.
ISAs: how much can you invest? - Anyone age 16 and over can invest in an ISA, but the amount you can invest each year varies according to your age:
- Age 16 and over, can invest £5,340 in a cash ISA only.
- Age 18 and over, can invest up to £10,680 split between one stocks and shares ISA and one cash ISA.
It’s important to note that these annual allowances cannot be carried forward to a future tax year. If you don’t take advantage of your annual allowance, you lose it.
In the Budget 2011, the government laid out plans to launch a ‘Junior ISA’ for those aged under 16. The details of this are scheduled to be revealed in summer 2011, an expected to be available by autumn 2011.
Another rule to be aware of is that you’re only allowed to invest in one cash ISA and one stocks and shares ISA each tax year (although you can transfer your cash ISA) – you cannot spread your savings around a number of providers. Furthermore, within the overall investment allowance only half of this amount can be invested in a cash ISA. You can choose what proportion of your allowance you want to invest in a stocks and shares ISA - you can even invest all of it in this way – but you cannot put more than half into a cash ISA. That means the maximum amount for a cash ISA is currently £5,340 if you’re over 18.
Cash ISAs: a long-term view - The financial benefits of a cash ISA really become apparent when you take a long-term view. If you’re saving regularly in a cash ISA and taking advantage of your allowance on an annual basis, as your investment grows the effect of compounding means a fairly modest short-term advantage can become much greater over time. That’s because the money in your ISA will always be tax-free, so while that may only represent a tax-saving of a few pounds in the first year, the saving will be far greater in ten years time when the overall interest you’re earning is much higher. And if you’re a higher rate taxpayer then the tax benefit will be even greater.
Transferring an ISA - As with all savings it’s a good idea to keep an eye on the interest rate your cash ISA is paying. Transferring to a new provider is normally possible, but it can take 30 days and sometimes there are penalties for doing this. It’s important to be pro-active about your investment and to make sure it’s still working for you. The specific rules around transferring ISAs can be found at HM Revenue & Customs. You will need to check with individual providers whether there are any penalties for doing this. Find out more about transferring your cash ISA.
Tax implications of stocks and shares ISAs - You don’t have to pay Capital Gains Tax on any growth in the value of your stocks and shares ISA fund when you sell, although with the annual CGT tax-free allowance set at £10,600 in the 2011/12 tax year, this may not represent such a big tax incentive. Furthermore, the dividends paid from a stocks and shares ISA still carry the 10% tax credit – you only receive 90% of the dividend, and you cannot claim back the 10% tax that has already been deducted. However, if you’re a higher rate taxpayer, you don’t have to make up the additional 22.5% tax.
Pensions and tax - A pension is a long-term investment with a tax wrapper and specific rules around the amount you can invest and when and how you can take the benefits from the investment. You get tax relief on your contributions up to a set limit. This means if you’re a basic rate taxpayer, for every £80 you contribute to your pension plan, the government gives £20. If you’re a higher rate taxpayer, the incentive is even greater, with the government contributing £40 for every £60 you put in.
With most pension funds you’re also eligible to ‘commute’ up to 25% of your pension pot at retirement, meaning you can take a tax-free lump sum payout. Regardless of whether or not you take this payout, when you draw your income at retirement, your income will be taxable.
Other tax-free savings schemes
NS&I is a government-backed savings institution and it offers fixed rate and index linked savings certificates that are free from Income Tax. It also offers premium bonds – in effect a lottery – and while you don’t earn any interest on premium bonds, your capital is secure and any winnings are free from tax.
Children’s savings and tax
Children have a tax-free ‘Personal Allowance’ in the same way that adults do, this is £6,475 for the 2010/11 tax year.
Interest on savings is classed as income, but is subject to specific tax rules, depending on who has deposited the money on the child’s behalf.
If the parents make the deposits into a child’s account, then the tax-free allowance of accrued interest is £100 per year, for each parent paying into the account. But, if the interest exceeds £100 per year, the whole amount is taxable on the parent – not just the excess over £100.
However, if the deposits are from friends and relatives, not the parents, then the deposit is treated as a gift and any interest earned is considered part of the child’s ‘Personal Allowance’ – and if the interest earned falls below the annual threshold then it is tax-free.
To make sure your child’s savings interest is not taxed at source, you need to complete form R85 when you open your child’s savings account. If you don’t, 20% will automatically be deducted from the savings interest – you can reclaim this tax using form R40 from HM Revenue & Customs (HMRC).
How will tax affect the return on your investment?
When you’re making a decision about where to invest your money, you need to factor in the tax implications of each product, based on your personal circumstances, in order to make a true judgement about what returns you’re likely to make.
Tax levels are reviewed annually. You can check the most up-to-date tax information from HM Revenue & Customs or speak with a qualified tax adviser.