Here in session number 19, we’re going to be talking about Tax. There’s a famous quote by Benjamin Franklin that is often rolled out in circumstances like this, so I don’t see why I should worry about being original! Here it is:

“In this world nothing can be said to be certain, except death and taxes.”

If taxes are as inevitable as that, we should probably know about how they work, why they are in place and how to legitimately work around them where we can.

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Before we get into the meat of the session, remember that this podcast is brought to you with the help of Seven Investment Management, a firm of investment managers based in London. They put their name to my show and to my site and videos because they believe in what I’m doing, and I’m very grateful for their support. You can see what they’re up to at 7im.co.uk

Listener feedback

John Fraase has been in touch and has asked me to do a show about value investing. Thanks for your email John; I’ll bear that one in mind. For now though, here’s a definition from Investopedia:

Value investing is: The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.

Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

So it’s the basic ‘buy it low and wait for it to go up in value’ approach to investing, as opposed to growth investing which is where the investor looks for companies with above average growth potential over time.

Thanks for getting in touch John. If you want to get in touch, then head over to meaningfulmoney.tv/feedback and there are a couple of ways to get in touch there.

Also, please do consider giving me a rating and review on iTunes – head over to meaningfulmoney.tv/iTunes to do that!

Introduction

So….. taxes. It’s rare, but it does sometimes happen that someone walks into my office to save tax. If this does happen, the client has usually sold, or is about to sell an asset of significant value and they want to know how to minimise the tax paid on the transaction. Usually though, tax is not a reason to make a big financial decision.

Let’s get another of Pete’s golden rules in place right at the outset here:

Don’t do something for tax reasons, that you wouldn’t do in any other circumstances

I’m sure that can be worded better. I’ve heard it expressed like this: Don’t let the tax tail wag the investment dog. Again, the idea is that tax planning should generally be lower down your list of priorities than the important things like investing for the future, or protecting your family against the worst.

Let’s be clear here. Most of us don’t have clever tax accountants and lawyers setting up offshore trusts so that we can pay as little tax as possible. We’re not in the position to do that, or to need to do it. For the vast majority of us ordinary, hard-working people, we need to resign ourselves to paying taxes, but be aware that there are many legitimate tax allowances and reliefs that we should definitely take advantage of.

One final note in the intro here: If I have a client come to me and say that they want to pay as little tax as possible, or even that they want to pay no tax, I won’t deal with them. I figure that if you’re going to drive on the roads or use the hospitals, you should help pay for them by paying some tax. People who are aggressive and obsessive about not paying tax, are usually quite unpleasant people who need to get a life – don’t let that be you!

Everything you need to KNOW

So, in learning what we need to know about taxes, we’re going to cover the three main personal taxes in enough detail for most people to be able to explain how they really work to their mates in the pub…

1 – Income Tax

Income Tax is a tax on income. Astounding insight there. Income from just about any source can and will be taxed, be it your earned income from work, a pension income, rental income or other investment income.

All your income from various sources is stacked up in a column in a specific order. So if you have a job your income from that is the bottom layer of the stack. Likewise if you are self-employed, your profits get taxed first, and your pension if you are retired. All these are termed ‘earned income.’

If you have interest from money in a bank, that’s next. Then if you have dividends from shares or other investments, they go on next, and finally other income, such as rental income from a buy-to-let property.

This stack of income is measured against a ladder. The ladder has bands of income tax, with different rates kicking in at different levels. This analogy works better with a visual aid, so I suggest you head over to Video Episode 199 to see what I mean.

Everyone gets a personal allowance, and amount you can earn from any source without paying tax. For the 13/14 tax year, this is £9,440 for under 65s. For those between 65 and 74, the allowance is £10,500 and for those over age 75, the allowance is £10,660. Eventually there will be a flat rate personal allowance for everyone. There are additions to the personal allowance for those who are registered blind, and those who are married and born before 6^th April 1935, but we won’t dwell on those. If you have income over £100,000 per year, the personal allowance is withdrawn by £1 for every £2 of income over that amount.

Over the personal allowance, you have three main bands. Income up to £32,010 is taxed at basic rate – 20%. Income between £32,011 and £150,000 is taxed at the higher rate – 40%, then anything over that is taxed at 45%, the so-called additional rate. All these figures are in addition to your personal allowance, remember.

If you are on a low income and get some interest from money in the bank, then there is a special savings rate band of income tax of 10%. So if you have for example, just a basic state pension, but have some money in the bank and the interest from that takes you over the personal allowance, you will pay 10% on the amount over the PA up to a total of £2,790

Dividends, have their own special rates of 10% for the basic rate taxpayer, and then 32.5% and 42.5% for higher and additional rate taxpayers.

One final thing to mention on income tax – national insurance. It doesn’t sound like a tax, but it is, and it’s a major one. It is charged on earned income only, so not interest or dividends or rental income. Just your earnings from your job or self-employment. Right now, in the 13/14 tax year, if you earn between £149 per week and £797 per week you will pay 12% national insurance on that income. Over £797 you will pay 2%.

So basically, you have different tax rates for different levels and different sources of income. Who’d be an accountant?! Actually, it is much easier to do this than it is to explain, especially without visual aids. Again go to video episode 199 for a visual explanation. I need to update this as it is based on a previous tax year, but the principles remain the same.

2 – Capital Gains Tax

You’ll be pleased to know that we got the worst over first in terms of complexity, the two remaining personal taxes are much simpler. The next is Capital Gains Tax, or CGT. As the name suggests, this is charged when you make a capital gain, i.e. When you sell something for more than you paid for it.

Certain things are exempt from CGT:

• Your main home
• Your car
• Personal possessions worth up to £6,000 such as jewellery or antiques
• Gilts
• Investments held in an ISA

Anything else is chargeable to CGT.

Like income tax, everyone gets an annual allowance for CGT, an amount you can gain in any one tax year. In the 13/14 tax year this is £10,900 for individuals. So if I sell a rare painting for £10,000 more than I bought it for, there will be no CGT to pay as the gain falls within my allowance.

If I sell it for £20,000 more than I bought it for, I take the annual allowance of £10,900 off the proceeds and the rest is the chargeable gain, £9,100. This amount is added on top of all my other income to see which income tax band I now fall into. If the gain, when added to my income keeps me within the basic rate tax band, I will pay 18% CGT on the gain. If it takes me into the higher rate band, I will pay 28% on the gain which falls into that higher rate band. If I’m already an HR taxpayer, I’ll pay 28% CGT on the whole gain

It is possible to offset losses against gains. So if you lose money on one thing and make money on another, you can use the loss to reduce the gain, thereby reducing your tax bill. You can even do this across tax years. So if you make a loss one year, you can carry it forward to future years where you may make a gain. You have to tell HMRC about the loss though, usually within four years of making it.

You can also offset any costs you incur in making the gain. So if I buy a property, do it up and sell it for a gain, I can take teh costs of the restoration, plus the estate agents and solicitor's fees off the gain I make.

There are various reliefs available to reduce CGT in other ways, which if I cover them all will make this interminably long. I’ll mention some of them briefly in the Everything you need to DO section later.

3 – Inheritance Tax

Finally we have the simplest of them all, Inheritance Tax, or IHT for short. This is charged when you pass money to other people when you die. How much is payable is a dead easy sum:

Everyone gets a tax-free amount that they can leave when they die. It is called the Nil Rate Band and it is currently £325,000. Everyone gets this, so if you are married, you get this allowance each, so £650,000 in total. If your estate, which is everything you own, less everything you owe, is worth less than the Nil Rate Band, there is no IHT to pay on your death. If it is worth more, then the amount over the Nil Rate Band is charged at 40%.

Money left to charity is always tax-free, no matter how much is left. In a marriage or civil partnership and the husband dies first and leaves everything to his wife it is totally tax free. There is never any tax between spouses. He also leaves his Nil Rate Band to his wife and she can use it in full when she dies.

Let’s say you have an estate worth £2million – why not give everything away to your kids just before you die, so there is no IHT to pay? Needless to say, HMRC have thought of that! If you give money away, you have to survive for seven years from the date of the gift. If you die within the seven years, the value of the gift is added back into your estate when they are working out how much IHT you have to pay. It is added back on a reducing sale, so the longer you survive the less is payable. After 7 years, the gift is deemed to be outside of your estate and is not included for IHT calculations.

There are reliefs and exemptions here too. If you have business assets, like shares in the family company, they can be left tax free in certain circumstances. Likewise agricultural assets for farmers. Again, these are outside the scope of this session, but the basics above are all that most ordinary people need to know.

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Three main personal taxes then: income tax (including national insurance), capital gains tax and inheritance tax. All with different rates, allowances, reliefs and exemptions. I’ve barely even scratched the surface there, and we’re already 22 minutes in. I’ve been told that the UK tax code is the most complex in the world, and that the number of pages in the full tax code more than doubled while Gordon Brown was chancellor. I don’t know if either of those things are true, but I do know that tax planning is a minefield, and that if you get it wrong, there can be big bills to pay, many of which may be unnecessary. I’ll say more about that later, but for now, let’s look at what you can do right now to work your way around the basic UK taxes.

Everything you need to DO 

1 – Income Tax planning

Use your Personal Allowance to the full. Everyone gets an allowance and it is applied automatically. If you are employed, it is taken into account when you are paid net of tax and NI; if you are self employed, it is part of the calculation of your tax payable. But if you are a couple where only one partner is working, it may be that the non-working spouse is not using their personal allowance. Any investments and savings should ideally be held in that partner’s name so that income produced by the money falls within their personal allowance and is therefore tax-free.

Use ISA allowances, both cash and stocks & shares. ISAs are tax-efficient savings plans and if used consistently, can be a useful hedge against income tax. You don’t get any tax breaks for putting money in, like you do with pensions, but the money in there grows largely (but not entirely in the case of S&S ISAs) free of income tax and totally free of capital gains tax. It’s a long term play, but if you are consistently saving into ISAs you are building up a pot of money which one day can provide you with a income tax-free income. I have clients with vast sums, hundreds of thousands of pounds, because they have saved in to PEPs and ISAs over many years. This is now paying them a very healthy tax-free income. You should also consider other tax-efficient savings vehicles like National savings certificates (when they’re available) and possibly Premium Bonds

Make contributions to pensions. Making a contribution into a pension extends the basic rate income tax band. So effectively, more of  your income is taxed at basic rate. This is particularly effective if you are on the cusp of paying higher rate tax. Making a pension payment could mean that all your income falls into the basic rate band. In effect, rather than pay more money to the taxman, you have paid that money to yourself in the form of a pension payment

Self-employed? Consider a limited company. If you are self-employed with a profit into the higher rate income tax band, then it may benefit you to operate as a limited company instead. Small limited companies are currently taxed at 20% on their profits whereas the higher rate income tax band is 40%. That said, companies don’t get a personal allowance, so you’ll need to do some sums to see if this is worthwhile. Talk to your accountant if you’re not sure.

Charitable giving for HR tax payers. Finally, if you have ever given money to a charity you’ll know about Gift Aid. This allows the charity to claim back the basic rate income tax you have paid on the money you have given to them. But if you are a higher rate tax payer, you can claim back the difference between the basic and higher rates (20%), effectively reducing your income tax bill.

2 – Capital Gains Tax Planning

Tax year planning. If you have something you want to dispose of which will produce a chargeable gain, consider selling it over multiple tax years. This works for things like share portfolios of course, but it’s harder to sell, say, a rental property in tranches! Sell enough shares in this tax year to realise a gain within the annual allowance of £10,900. Then when April 6^th rolls around and a new tax year begins, you can sell another lot of shares as your allowance has been reset.

Use both partner’s annual allowances. If you hold an asset in your own name, consider transferring some of it to your spouse or civil partner. They have an allowance too, so rather than incur a tax charge on a portfolio of shares, give half the shares to your spouse and have him/her sell them. There is never any tax to pay between spouses, so you can give assets between each other with no tax implications.

Main residence exemption. Be careful here, but if you are lucky enough to have more than one property, you can elect which one is your primary residence and sell that free of CGT. This, you may remember, was what our MPs were up to in the expenses scandal back in 2009(?). It’s a fine line between cynical manipulation of the system and genuine tax planning.

Offset losses against gains. Remember that you can use past losses to reduce future gains and only pay tax on the difference. Make sure you are registering any losses with HMRC on your tax return and use this valuable concession to reduce your CGT bill.

No CGT on death. It’s pretty difficult to know when you are going to die, but Capital Gains Tax dies with you. So if you hold an asset with a large latent gain, which if you sold it or gave it way would give rise to a big tax bill, you can give it away via your will instead with no capital gains issues for your estate. There may be Inheritance Tax implications of course, but more on that in a second

Use all possible allowances, exemptions and reliefs. There are lots of ways to mitigate CGT, and for many of them you should consult an accountant. Space here doesn’t permit me to go into detail – maybe in a future session.

3 – Inheritance Tax Planning

Spend all your money, or give it away. By far the best way to reduce your inheritance tax is not have enough money when you die that you have to pay it! If you can spend your last penny the night before you die, then that’s perfect, but none of us know when that’s going to be. Obviously, we want to make sure we have enough money for the rest of our lives, especially if we need care one day. But careful planning can mean that you can spend or give away money and be sure that you still have enough left

Use gift exemptions. Everyone gets an amount of £3,000 that they can give to any one person each year, so this is a great way to reduce your estate gently. You can even go back one year if made no gifts last year, and give away £6,000 this year. There are other exemptions for making gifts for a family member’s wedding. You can make as many small gifts of £250 to as many people as you want. Better still, if you make gifts regularly and they don’t affect your standard of living, you may be able to use the gifts from income exemption to make larger gifts each year. All these are there to be used, so use ‘em!

Beware of gifts with reservation of benefits. Many people ask me if they can give their house to their kids while they are alive, and take advantage of the seven year rule to save inheritance tax. I always say: “Sure you can, but where are you going to live?” They usually look at me as if I’ve gone crazy. But the fact is, you can’t give something away and continue to enjoy a benefit from it yourself. It just doesn’t work. HMRC will deem that you still own the property, even if it is now in your children’s names. The same goes for paintings given away that still hang on your wall, or holiday homes that you still visit.

Use Business Property Relief. This relief says that if you hold a qualifying asset for two years, and you still hold it at the date of death, that money passes down a generation IHT free. This relief is designed for family firms to be passed down the generations. There are investments which also qualify for this relief. They can be risky though, so be careful and make sure you understand the risks before you invest

Use trusts. There are various schemes using trusts which are designed to reduce your inheritance tax bill, either immediately or over time. These can be quite complex, and always involve some element of giving money away into the trust. As a trustee  you would still control the money, but you may not be able to benefit from it any longer, due to the gifts with reservation rules above. Trusts are a specialist area, so make sure your financial planner knows what they are doing, and seek advice from a solicitor too.

4 – Get a good accountant

I’m a really big believer in letting everyone stick with what they are good at and not get involved with things that other people can do better. An accountant is a tax specialist. It’s what they do all day. A good accountant can earn their fees many times over in the amount of tax they can save you.

Well that’s five planning angles for each of the three major personal taxes. Make sure you are getting help with this important element of your financial planning. Charges and unnecessary tax are killers when it comes to the performance of any financial plan, so using the angles above to reduce your tax bill legitimately is really, really important.

Outro

That's it for this session of the MM podcast, I hope that was helpful. Did I miss anything? Any questions or comment? Please leave them at in the comments section below and I'll do my best to answer them.

If you like what you hear on this podcast, please leave a rating or review on iTunes at meaningfulmoney.tv/itunes. This helps others to hear about the show and to subscribe.

I hope you enjoyed this session. Next time we'll be talking with Justin Urquhart Stewart about what’s going on in the world economies and the impact on your finances. If you have any questions about this, go to meaningfulmoney.tv/feedback and leave a voicemail.

Thanks for listening – I'll talk to you next time.