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The value of minimising your tax liability

Efficient tax management can make a significant difference to your overall return
The value of minimising your tax liability

As this week’s financial planning feature shows, a one percentage point increase in the overall cost of investing in a global equity tracker over the past two decades would cost you 18 per cent in overall performance. This is almost as much as the 20 per cent top rate of capital gains tax (CGT) charged on profits realised over the current annual allowance of £12,300. 

If fees are one of the biggest predictors of your returns, tax management is one of the most powerful tools you have to manage how much your investments are worth when you crystallise them. I’m sure you know that if you put your money into an individual savings account (Isa) it can grow tax free. But money outside tax wrappers could be subject to dividend tax, income tax and CGT, which are charged at different rates. 

How much could this cost in the long run? Let’s say you have a £100,000 portfolio with a 4 per cent annual yield, which is taken as income and paid in dividends, with 1 per cent capital growth each year after charges. Laith Khalaf, head of investment analysis at AJ Bell, calculates that over 20 years this would deliver £88,076 in income. And if the portfolio is not held in a tax-efficient wrapper, a higher rate taxpayer would pay £16,226 in tax and an additional rate taxpayer £18,918. It’s a big expense, despite being able to receive dividends worth £2,000 each year tax free.   

If the benefits of tax wrappers such as Isas and pensions are already well known to you, those of you who still have money outside these wrappers can manage your CGT position and also make a big difference in the long run. Vanguard’s James Norton gives an example.

You have a general investment account worth £100,000 that grows at 5 per cent for 20 years. You make no transactions, but sell and pay any taxes at the end of the period. After 20 years, your account is worth around £265,000 – a pre-tax gain of £165,000. If you are a higher rate taxpayer with no losses to offset against gains, you would owe CGT of £30,540. This results in a net gain of £134,460 or a net annual return of around 4.35 per cent.

If you used your annual CGT allowance each year, assuming the current level of £12,300 remains unchanged, you would end up paying under £100 in tax. This is because each year you had realised gains and offset them against your CGT allowance, and only in year 20 would the gain be a little over £12,300 and subject to tax.  

Apologies if I’m teaching you how to suck eggs, but I hope it’s helpful to look at examples of how much difference using tax wrappers properly can make. The rules governing inheritance tax, pensions, trusts, family investment companies, CGT and lifetime Isas can be complex, but it's worth getting on top of them to boost your post-tax returns. The difficulty is that we have no idea how rules might change over the next two decades, which makes it all the more important to make the most of what’s on offer while you can.