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:
- Interest from most savings.
- Income from a pension.
- Rental income.
- Dividends from shares.
- 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(£11,500 in the 2017/18 tax year), those 65 and over are entitled to enhanced personal allowances. Beyond this threshold you will start to pay tax.
Any money that you 'receive 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 2017/18 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 £45,000
- You pay 40% for any income above £45,001
- 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, if it's residential property this will be between 18% to 28%.
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 £11,300 for the 2017/18 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.
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
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.