Investing outside an ISA

danrfd

Hi, I have already invested my ISA limit and am about to invest some more money in funds. I'm trying to get my head around the tax implications. Will certain funds have a tax advantage based on the type of income they generate? Would I avoid some tax by investing in growth rather than income based funds?

Thanks!

ColdIron

bowlhead99 gave a very lucid reply to a similar question earlier

http://forums.moneysavingexpert.com/showpost.php?p=63674153&postcount=74

Income or Accumulation makes no difference

danrfd

Hi and thanks for the link, however, I am still a little confused as to how taxation on funds works.. Is there a difference in taxation on:

A) A fund investing in smaller companies with higher growth but with lower dividends.
A fund investing in larger companies with less growth but high dividend yield.

Thanks!
Dan

westy22

A fund investing in smaller companies with higher growth but with lower dividends.

The growth (or rise in share price) will be treated as a Capital Gain when you sell the shares - therefore subject to CGT if it exceeds the annual allowance (£10,900 in 2013/14)

A fund investing in larger companies with less growth but high dividend yield.

Any growth will be treated as above but the dividend yield will be treated as income in the year it is paid and taxed according to your tax rate. Basic rate tax payers will have no further tax to pay; higher rate taxpayers will have additional tax to pay.

Exactly as Bowlhead99 said in the link above.

ColdIron

westy22 wrote: »

the dividend yield will be treated as income in the year it is paid and taxed according to your tax rate. Basic rate tax payers will have no further tax to pay; higher rate taxpayers will have additional tax to pay.

Terminology is important. Dividends from equities will be treated as dividends not income. Income, from for instance bonds, will be treated as income and income tax is payable even for basic rate taxpayers. Other than that, spot on

bowlhead99

Effectively yes there is a generally difference depending on your tax situation, because dividends are taxed as income and capital growth followed by a sale is taxed as a capital gain.

If they pay you a lot of dividends you pay income tax. Say you invest £100 in Company B and they make enough profits in the year to send you £10 after tax and still have your share of the remaining assets in the company be worth £100. If you were a basic rate taxpayer receiving the £10, you would get a tax credit covering your tax bill so nothing net to pay, but a higher rate taxpayer would have to declare it and pay tax, as the tax credit would not fully cover his bill.

Compare that with Company A. If they don't pay dividends you don't pay income tax. But if they are making all these profits and choose not to pay out the £10 of dividends, instead reinvesting it to create a company worth £110 instead of £100, you will be faced with a potential capital gains tax bill when you sell the company for £110 having only paid £100 to buy it.

So, if you sold 'Company A' you would have £10 of capital gains. Whatever tax band you're in, you would add it to other capital gains that year. And then you would offset any capital losses that you cashed in that year. If the net result is a loss, you could carry that forward to offset against future gains in later years. But if there was still a gain, you can offset your annual exemption of around £10,900 mentioned by Westy above. Only after that would you actually pay tax on the final net gains figure, the CGT rate is 18% for basic taxpayers and 28% for high rate taxpayers.

If you had invested in the high growth company, but wanted access to the £10 one year (but didn't want to sell your whole stake in the company), you could just sell a part of your investment. If your £110 holding was made up of 1000 shares at 11p you'd need to sell 91 shares to get your hands on £10.00.

Those 91 shares cost you £9.10 (when you bought them at 10p each) and so you have £0.90 of gain. As £0.90 is well under £10,900, there is no capital gains tax to pay and whether you are a high rate taxpayer or a low rate taxpayer you have got away without paying tax.

For a high rate taxpayer, using higher growth shares to expose yourself to capital gains tax (where you have a fixed annual exemption) rather than income tax (where your annual allowance is already used up by salary or pension income) is useful. Managed well, and selling investments each year to buy back inside ISA or pension can reduce the tax to virtually nothing.

A basic rate taxpayer might be wary of doing that, because their dividend streams carry a full tax credit so they don't ordinarily pay tax on them, while a huge amount of growth might attract capital gains tax if they are not smart enough to split their sales across different years, or they just get too damn much growth (nice problem to have).

So from that, you can see different groups of people might prefer their total return to be split in different ways from a tax point of view. Of course, to answer a question you didn't ask, you shouldn't let the tail wag the dog.

In other words, don't buy some high growth small company shares just because you think the tax bill would be slightly better. They may crash in a market downturn losing more than half your money, while the large stable dividend-paying companies only fall a fraction of that because they are more resilient to the economic changes and their reliable dividends are are very much in demand when growth opportunities disappear. By contrast don't avoid growth stocks during a stock market boom in favour of slow boring dividend payers.

The first thing to get right is what portfolio gets you a good return in the market conditions you might face and results in the balance of risk and potential reward that you want ; what that reward looks like after tax is a secondary consideration for most people, as they want to balance the risks first and foremost. You only have a tax bill to worry about if you first build a decent portfolio :-)

danrfd

Thanks for the fantastic reply! This is very helpful - exactly the info I was after. It seems in my scenario as a higher rate payer who has already invested the ISA limit in FTSE focussed funds to aim to invest further in growth focussed funds (assuming it makes strategic sense for the portfolio).

bowlhead99

Glad it helped. The 'strategic sense for the portfolio' is the important bit.

If you didn't already have any growth funds in your portfolio, adding them somewhere makes sense, and keeping them outside the ISA also makes sense because you may feel you need the ISA protection on your bonds and income funds. If however your ISA was full of growth funds, and you were looking to make further investments outside the ISA, then picking growth funds because of some perception of potentially better tax treatment could be a mistake.

But once you have a substantial portfolio both inside and outside wrappers, it is probably worth rejigging what you have held where to maximise tax efficiency.

Another factor worth mentioning is that higher risk growth stocks, if well-picked, or just in the right part of an economic cycle, can give much better overall returns than something like bonds. This is important to recognise because it could give a counter-intuitive result and significantly affect your planning when you realise what is going on.

The examples I gave in the previous post would have you invest your safe income paying stuff inside the ISA for tax efficiency... BUT:

In my ISA I have several thousand pounds worth of Lloyds Bank preference shares. They yield 7-8% as dividends on their current value, which would be a double-digit yield on what I actually paid for them before they went up by a good percentage over the last couple of years. So from tax perspective, high yield and good capital gains - but not great potential capital gains like the same bank's ordinary shares to use up my CGT allowance - makes sense to have these lower risk shares in an ISA (or SIPP, as I also do), rather than unwrapped, right?

Well yes and no. The Lloyds ordinary shares, recovering from their collapse, have trebled in the last few years - putting on maybe 70-80% in the last year. No dividend. Compared to the Lloyds preference shares putting on 10% of price and 8% of dividend in the last year. As dividends are very taxable and capital gains taxes can be very avoidable with planning, the use of an ISA for the prefs seems sound and non ISA for the ordinaries makes sense. You may be nodding along thinking this tax planning lark is easy... but, keep reading...

If I had put an entire years ISA allowance in the Ordinaries a year ago, I could have grown £11k to almost £20k. Instead, putting an entire ISA in Prefs means I only grow the £11k to £13k. Meanwhile maybe I'm still buying £11k of ordinaries outside the ISA and turning them into 20k without a CGT bill because of a nice fat annual allowance - so in total I've turned £22k into £33k, with zero tax. Great result. Doing it the other way round with the ordinaries in the ISA wrapper I'd still get gross returns of £33k but have a tax bill on £1k of pref share divs which would have wasted a few hundred pounds of tax lost forever to HMRC. I was correct to use the ISA for the boring dividend payers, right?

Actually, it might not be right at all. Because the end result is that I have £13k of wrapped assets and £20k of unwrapped assets. Instead of £20k of wrapped assets and £12 point something k of unwrapped assets. Sure, I have greater assets. But arguably, that extra chunk of wrapped assets in the alternative scenario (which can be changed into any other shares or funds I fancy, within the wrapper) has an inherent extra value. The wrapped assets can grow and pay tax free income or gains compounded for the next 50 years of my life.

The unwrapped assets, which can't fit into a wrapper because I already plan to max my annual subscription for the forseeable future, will pay taxed income or taxed gains compounded for the next 50 years of my life. You could do the maths and work out how this could be a substantially different lower sum, eventually. So, thinking I am smart and putting safe boring shares in the wrapper to save a few hundred pounds of dividend tax this year has cost me something in the long term because I'm not growing the wrapper in the way that would make me an ISA millionnaire any time soon.

This is not to say you should go out and buy some massively risky funds for your ISA to try to grow it as fast as possible, because you could easily shrink it just as fast. Real-life examples:

I added to my holding of BLNX, an AIM listed tech company last summer at under 40p and they are 200p now. If AIM shares had been allowable in ISAs last year, as they are today, I could have quintupled that asset within my ISA wrapper and exited for a permanent boost to my tax free status.

But 18 months ago I also bought some VOG, an AIM gas explorer/producer at 3.75p. I have bought more and averaged down since so my overall cost per share is now lower than that, but the shares today are only about a penny. If that investment had been to try to double or treble or quintuple my ISA allowance, I would have been pretty annoyed to halve or quarter it instead.

Obviously we do not invest for a year or 18 months at a time (and I'm happy to keep my VOG, and in fact added to it recently), it is worth keeping in mind the old tenet 'the value of investments can go down as well as up, past performance is not indicative of future results ', etc. The point is that generally we know some asset classes will produce greater returns than others over a long period and so generally they would be good to use to grow the absolute size of your tax wrapper, even if that means we pay tax on other things along the way during that growth phase. Just a thought.

danrfd

Thanks again for the very informative reply! I had not really considered this aspect to the equation - namely the fact that gains made within an ISA are kept within the ISA. High gains will therefore have a big compound effect on tax efficiency over a lifetime.