The title is a play on words from George Orwell’s novel Animal Farm: ‘All animals are equal, but some animals are more equal than others’.
The concept arose in a recent meeting with a client. They required a large withdrawal from their portfolio at short notice. Due to the period of investment, large gains had built up within the account. I explained that a Capital Gains Tax charge would apply. The portfolio value didn't reflect the value of money in their hands.
It was like getting a good pay rise and worrying about paying income tax. Nobody in their right mind would reject a large pay rise on that basis.
This led me to consider how different investment options affect the outcome. How do the investing public value these options?
Is each pound invested and saved by you equal when it comes to spending it? This is where financial planning comes to the fore; aligning investments in a sensible and logical manner. Investing is deferred spending, and it requires careful thought.
Can you get your hands on your money? When can you get it? Are there any restrictions? What about tax? Outcomes can be increased by limiting the tax paid.
Imagine that your choices are empty glass jars of various sizes and shapes. You hold a jug filled with liquid cash and don't know where to start pouring.
The decision is affected by taxation either at outset, along the way, or at exit. Or perhaps all three. Taxation is an important factor, but so is security and access. You will be investing for a reason, a future objective. Making this possible is at the heart of financial life planning.
It is important to fill your investment jars in the best order for you and your family. And the order in which you drink from each one will have a major effect. To do this without expert guidance may result in unwanted spillage.
If you want to give someone £100, they may get £100, £80, £60, £55, or some other outcome. Huge variables are based on life choices.
Let’s start with simple cash in the bank or held with NS&I. The initial £1 saved will remain at £1. Any interest earned (now paid gross) may be subject to Income Tax at your marginal rate of tax. A second factor is inflation, reducing the buying power of the £1. The third factor is potential Inheritance Tax (IHT). Cash sits in your estate on death.
The cash ‘jar’ is of unlimited size (NS&I have limits). Investor protection is limited to £85,000 per person per cash ‘provider’. Basic rate taxpayers may benefit from the £1,000 Personal Savings Allowance. Higher rate taxpayers get £500, and addition rate taxpayers don’t get anything.
You can invest up to £20,000 each tax year into an ISA. If invested in a portfolio reflecting the global economy, the return should exceed inflation. Any income, dividends, or interest generated is free from income tax. On exit, the ISA is free from Capital Gains Tax (CGT). On death the ISA can be inherited by a surviving spouse or civil partner and it retains the tax-exempt status in their name.
The ISA assets will form part of your estate for inheritance tax purposes on your death (unless the ISA is the type qualifying for Business Relief, e.g. AIM ISA). If your estate is passing to your spouse or civil partner the ISA is exempt from IHT.
On your spouse or civil partner’s eventual death, the ISA forms part of their estate which may be liable to IHT.
Personal Pension and SIPP
There are a host of different forms of UK pension, but the basics are similar. Regular savings or lump sums to prescribed limits attract tax relief at your marginal rate of tax. That’s a nice incentive to save. Your money grows tax-free (like an ISA). Regulated pension plans don't incur CGT.
From age 55, you should be able to access your pension benefits. Up to 25% of your pension pot is available as a tax-free lump sum. The remaining 75% will be subject to income tax at your marginal rate.
On death, your remaining pension fund can be inherited by your beneficiaries, free from IHT.
Discretionary Fund Management-stocks and shares and collectives
The non-ISA element will be subject to income tax at your marginal rate on all interest and dividends that exceed your Dividend Allowance and Personal Savings Allowance (if available). There are three dividend tax rates: 7.5%, 32.5% and 38.1%. The rate depends on whether the dividends fall in the basic, higher or additional rate tax bands. For shares, there will be Stamp Duty/Stamp Duty Reserve Tax on trades made. Most professional fees to DFM managers attract VAT.
Any realised growth may be subject to CGT (individuals have an annual exempt amount to help reduce any CGT). The portfolio on death will form part of your estate for IHT but any portfolio CGT is erased on death.
Since April 2018, everyone gets a £2,000 Dividend Allowance.
General Investment Account/Personal Portfolio
Like the DFM above, the GIA/PP doesn’t have a tax ‘wrapper’. Gains may be liable to CGT (don't forget your Annual Exempt Allowance of £11,700). Any income may be liable to income tax. These accounts typically don’t hold company shares; they usually invest in collectives – unit trusts and investment funds.
The portfolio on death will form part of your taxable estate for IHT, but any portfolio CGT is erased on death.
Offered by traditional life insurance companies. Basic rate income tax is paid on the unit price. Any capital gains over time are charged to Income Tax above the basic rate.
Each year the investor can withdraw up to 5% of the original capital sum without an immediate income tax charge. On death, there may be a further charge to income tax. The Bond value (unless protected by a trust) will form part of your estate and may be liable to IHT.
Unlike their onshore bond cousins, the offshore bond doesn’t accrue a basic rate tax charge on an ongoing basis. The funds roll up on a gross basis except for any element of irrecoverable Withholding Tax. The 5% rule remains the same. On withdrawal or exit, any gains made become liable to income tax at your marginal rate. There is no CGT.
The Bond value (unless protected by a trust) will form part of your estate and may be liable to IHT.
This is a modest recap of seven popular investment options. Property will be the subject of another blog. Please don’t rely on this guide without first taking independent advice. There are a host of rules and regulations to negotiate.
At Capital, we believe that the sequence in how you invest, and the sequence of how you withdraw has a huge effect on the outcome. Not for the DIY enthusiast.
The value of investments can rise as well as fall, and your capital is at risk.
UK pension complexity is such that this blog can only cover the basics and Defined Benefit pension schemes have not been included for that reason.