This is potentially a long read if you choose to read it all. If however you do not have any investments held within a General Account you can pass on a long technical section and fast forward to later in the blog. The jump link comes about a page lower from here.
I like the US holiday of Thanksgiving. The holiday is held on The fourth Thursday of November with the annual day set in stone by Congress in 1941.
Thanksgiving is day for US families to get together and enjoy eating too much turkey. Many watch a full programme of (American) football games with the extended family. A day to be grateful and celebrate being an American. This Thanksgiving finds us on a ship full of Americans and we too are celebrating alongside them for differing reasons. We are grateful that Wednesday’s UK budget wasn’t half as bad as expected. It wasn’t good for hard-working retired savers, but it could have been much, much worse.
It’s sad to think that if we in the UK tried to celebrate the history of our once great nation, on any particular day like Thanksgiving, half of the population would accuse us of being racist or colonialists. Why can we not be proud of our nation and culture like the Americans surely are?
We can afford to celebrate, particularly with the Americans, as the majority of our investment growth this year has come from harvesting the strong performance of US companies. Although the majority of Americans celebrate Thanksgiving, half of Americans are not thankful for the current political leadership in the US. This dis-satisfaction with our current government is also true on this side of the pond, for the majority of the UK population too. We both live in nations that are deeply split, but here in the UK we don’t have a national holiday to try to bring individuals together to resolve their differences. It’s a pity.
Anyway let’s talk about the real reason we in the UK are celebrating the day after Wednesday’s budget on Thanksgiving day. The tax rises announced weren’t as bad as we all feared. This blog was originally titled “The nightmare before Christmas”, perhaps I will save that for Torsten Bell’s first budget next year when he takes over the reins as the next Chancellor of the Exchequer.
So like a prisoner on death row, I feel this budget is a reprieve rather than a pardon. Let’s see how we as investors will be affected. Although we talk about tax in the singular, UK taxation is made up of many moving parts so I will split it down by taxation and investment vehicle. To keep things simple I will not include either onshore bonds or offshore bonds in this quick comparison as the taxation is mostly hidden, both internal and external, hence quite complex.
| Taxation | On Interest | On Dividends | On Gains | On Withdrawals |
|---|---|---|---|---|
| Bank Account | Yes | N/A | N/A | No |
| ISA | No | No | No | No |
| General | Yes | Yes | Yes | No |
| Pension | No | No | No | 25% Tax Free |
| Drawdown | No | No | No | Yes |
No = No Tax, both before and after this budget announcement. There is nothing to see here or wonder what the changes will cost you.
Yes = These areas were taxed before and a 2% additional burden has been added.
Yes = Drawdown income was taxed before but the rate has not changed in the budget.
As you can see from the above table, it is within General Accounts where most of the tax increases have occurred. General Accounts have always been subject to taxation. A bank account can for taxation purposes also be described as a General Account that may only hold cash. A General Account can also hold cash, but it can hold most other tradable investments such as shares and funds.
Taxes on General Accounts.
At the core of a General Account is a bank account. Any amount not invested in a share or a fund is held as a cash deposit with immediate access. Cash on Transact currently returns 3.67% per annum in interest. The level of interest rises and falls with Bank of England interest rate projections. The tax on that interest is subject to savings tax rates, a form of income tax which was previously charged at the exact same rate as income tax but now carries a further 2% taxation penalty.
Income Tax & Savings Tax
UK income tax is banded. This means if total income breaches the upper level of a tax band, only the amount above that band is subject to taxation at the next higher rate. If you become a higher rate tax-payer you only pay the higher rate above £50270. There is;
- Earned income – income derived from your labour – salary, wages, bonus etc.
- Un-earned income – income derived from savings and investments.
Earned income has remained unchanged in this budget. The rates remain the same. The “Working Man” has been spared. Self-employed individuals continue to pay the same rates of income tax as employed individuals. However if the self-employed income is derived from renting property, the further 2% tax burden is added.
There is a hierarchy of taxation with State Pension coming first, then income, then unearned income then savings and finally dividend income. Capital Gains Tax is calculated after all income tax has been taken into consideration.
Everyone has a personal allowance before income tax becomes due, both in our working lives and throughout our retirement years. This is currently frozen at £12570. It’s not kept pace with inflation for years and the freeze has just been extended for many more. Therefore for most pensioners the State Pension is currently free from tax, but it means for any additional sources of income, they are likely to suffer taxation starting from at least 20%. Those additional sources could be;
- Continued employment
- Self Employment
- Annuity (personal pension) payments
- Public sector superannuation income
- Private sector company pensions
- Pension drawdown.
On bank interest and property income it will be 22%. Let’s try to show this in table form.
It’s best to start this table from the bottom at zero and work upwards until the income level has no personal relevance.
| Income Level | Tax on Income | Tax on Savings | Notes on Earned Income Tax |
|---|---|---|---|
| Above £125,000 | 45% | 47% | 45% from here on earned income |
| £125,140 £100,001 | 60% | 62% | 40% tax continues on income, but above £100,000 the personal allowance is taken back at the rate of £1 for every £2 earned. This adds a further 20%. |
| £100,000 £50,271 | 40% | 42% | 20% basic rate ends and 40% higher rate begins on earned income above £50270. Plus 2% for interest and rental income. |
| £50,270 £12,571 | 20% | 22% | Basic rate taxation remains at 20% unless that income comes in the form of bank interest or property income. |
| >£12,570 | Zero% | Zero % | From April the new State Pension rises to £12,547.60, using all but £22.40 of an individuals personal allowance! |
There is an allowance on savings income which allows a small amount of savings income to be tax free. If you are already a 40% tax-payer before savings income is added, £500 of income is tax-free. If when savings income is added to your income you are still not a higher rate tax-payer then £1000 is tax free. If you already are a higher-rate tax-payer, all interest is taxed. Only once all sources of income are calculated and taxed, does the calculation of the tax due on dividends take place.
Dividend Tax
Dividends are taxed next on top of total income and savings. The bands are identical to those shown above.
| Income Level | Tax Was | Tax Now | Notes on Dividend Tax |
|---|---|---|---|
| Above £125,000 | 39.35% | 39.35% | No Change. Any higher would close businesses. |
| £125,140 £100,001 | 53.75% | 55.75% | 35.75% dividend tax plus of £1 for every £2 earned. Loss of personal allowance. |
| £100,000 £50,271 | 33.75% | 35.75% | Lower than income and savings taxes |
| £50,270 £13,071 | 8.75% | 10.75% | Less than the tax rates on forms of income which are roughly double |
| +£500 | Zero% | Zero% | £500 tax free dividend allowance. |
| <£12,570 | Zero% | Zero % | Personal Allowance available if unused. |
Capital Gains Tax
Capital Gains Tax on the profits from selling shares is calculated only once annual income has been taken into account. If gains can be added to income and savings and still not breach £50,270 overall, the tax on your gains is limited to just 18% (slightly better than 20% or 24%). For higher-rate tax-payers and above the rate is just 24% (significantly better than 40% and 42%). Each individual also has a £3000 allowance before tax becomes chargeable. This allowance is used or lost each tax year.
Continuing Investment Strategy for General Account Investments.
For investors whose overall annual income remains within basic rates, the following table illustrates the tax due. Let’s use a £100,000 General Account as an example where we assume an overall return of 7%, which is the annual target for our Moderate Portfolio.
| Allocation | Interest | Dividends | Capital Gains | Total |
|---|---|---|---|---|
| 20% Cash | £734 | £734 | ||
| 10% Gold | £700 | £700 | ||
| 70% Equities | £894 | £4672 | £5566 | |
| £7000 |
Conclusion
As you can see from the figures above, our total return investment philosophy, relies very little on creating a return from income generating assets such as dividends and interest. The current annual dividend yield is just below 0.6%.
The majority of each year’s return comes from capital gains, where the taxation rate is lower than savings tax rates. It was increased at the last budget but spared at this one from a further increase. The rate is 18% for individuals in the basic rate tax band and only 24% in the higher tax bands on gains – better than savings tax at 22% and 42%. The second highest returns come from dividends where the tax payable is also lower than that on savings income. All highlighted in the table below.
Model taxation for a basic rate tax-payer
| Savings Allowance | Dividend Allowance | CGT Allowance | Taxable | Tax Due | |
|---|---|---|---|---|---|
| Interest | £1000 | £734 | £0 | ||
| Dividends | £500 | £394 | £42 | ||
| Capital Gains | £3000 | £3266 | £588 | ||
| £630 |
The net result is a composite rate of just 9% tax is paid on the £7000 profit. (630/7000) If we were to compare this with £100,000 in a bank account giving a full 3.67% over the year, the gross interest would be £3670. The taxable amount after the personal savings amount was taken into account, would be £2670 with tax due at 22% leaving a net return of £3082. The tax rate on £100,000 in the bank would be 16%. (588/3670)
In a Nutshell
From the example above, where investment capital needs to be held in General Accounts as full ISA allowances have already been utilised, next years tax bill will be higher than it was before the first and recent Labour budget tax rises to the tune of only around £55.00. Not exactly the end of the world for those with £100,000 savings behind them.
Politics
We endeavour to discount party politics, both domestic and global, to attempt to get a better than average investment return. That return is not based on which party we vote for personally. Obviously over the weekend there have been many accusations of incompetence and outright lies from our current government. Lying governments are universal so there is no story here that is new. To us, that simply means we will continue with our central belief that overseas investments held predominantly in dollars will continue to beat domestic UK shares held in, likely to weaken, UK pounds over the short to medium term. The middle ground is exceptionally large international companies listed on the UK market that earn much of their income in dollars. Here the share price will strengthen as Sterling depreciates. Rolls Royce is a good example.
We have been told the limits on cash ISAs are to help UK business investment. I cannot see that is true when an ISA can currently invest in any listed security worldwide. A UK investor could use their full £20,000 ISA allowance to invest solely in Chinese companies. How does that help UK company investment? Unfortunately we see it as a tax on the overly timid, reducing their tax-free interest to help pay an increasing benefits bill.
Continued Frozen Tax Allowances
The real hit to each and every one of us is the extension of the tax bands freeze. The personal allowance was frozen in 2021/22 tax year at £12,570. To be fair it had already more than doubled from 2008/09 when it was just £6035. The increase was a combination of action taken after the Great Financial Crash and a UK coalition Government that had to stick to a Lib Dems manifesto promise of lifting the personal allowance to £10,000. Maybe the climb was too much too fast, but the freeze since has proved brutal. Taking inflation into account since the freeze began, the current personal allowance should be about £15,750. From a taxation perspective, each and every one of us loses about £600. As all tax thresholds have been frozen, a further hit occurs for higher rate tax-payers. The freeze at £50270 by now should be almost £14,000 higher at £64,000. That freeze drags an increasing number of “hard-working” individuals into paying higher rates of tax. For those who were already paying higher rates in 2021, they now pay a further £2800 in income tax.
So net take home pay has decreased for all workers whilst benefits have increased for non-workers. Something must change or eventually everyman and his dog will cease pursuing a meaningful endeavour and consign themselves to the couch with an all-inclusive paid for existence.
The effect on Pension Drawdown
Many clients understandably do not wish to be higher-rate tax-payers in retirement. Many are in Drawdown and are free to do something about it. Drawdown is the perfect way for many to take their retirement savings due to its inherent flexibility. Withdrawals can be started, stopped, resumed, increased and decreased. Many clients have tried to freeze their overall income level just below £50270 since 2021. As State Pensions have kept pace with inflation, but tax thresholds have been frozen, many clients have asked to reduce pension withdrawals. Obviously their pension account has grown to be larger than it would have been had the withdrawals been increased, but the time left to enjoy the increased amount continues to run out. The announced extension to the tax allowance freezes until 2030/31 tax year, 5 years from now, will force many individuals hands. In retirement every year is precious. I doubt their tax-aversion resolve will go the distance for many clients even if it means paying back some 40% tax in retirement on pension savings they only received 20% tax-relief on their contributions.
And finally ISAs
It became clear to me many years ago that the tide had turned for the tax benefits of pensions over the tax free simplicity of Individual Savings Accounts. We have encouraged many clients to use their full allowances and automatically transferred the maximum each year where clients also held General Accounts with us. Thankfully neither the annual ISA contribution allowance nor the maximum investment holding level have been reduced in this budget. It’s a huge comfort that our combined tax free ISA holdings now total over £35 million. That’s a huge source of tax free withdrawals available to fund our future lives.
Happy Antarctica Day!