Vanguard LS lifestyling adjustment

bluebell321

I notice that LS20 pays interest whereas the others pay dividend. I'm sure I've read here that some of the LS are better suited in ISAs than unsheltered. Could someone explain which and why please? Thank you.

dunstonh

Everything should be in ISA unless you have no ISA allowance left or you require a trust based arrangement. It doesnt matter if its interest or dividend.

However, if you are investing more than the ISA allowance and have some unwrapped holdings, it can make sense to have your fixed interest securities in the ISA as they can claim back the tax paid on the distributions. Whereas there is nothing to claim back on equities.

bluebell321

Thanks. So just for example to check my understanding , if LS60 was desired, it would be financially better to hold equal amounts of LS20 and LS100 inside an ISA to get the equivalent of an LS60 but some tax reclaimed?

badger09

bluebell321 wrote: »

Thanks. So just for example to check my understanding , if LS60 was desired, it would be financially better to hold equal amounts of LS20 and LS100 inside an ISA to get the equivalent of an LS60 but some tax reclaimed?

I must be missing something

Why not simply hold LS60 inside the ISA?

bluebell321

badger09 wrote: »

I must be missing something

Why not simply hold LS60 inside the ISA?

That's why I posed my question. Only LS20 pays interest instead of dividends. If I understood the previous poster correctly, the other LS options might not allow refund of tax within an ISA whereas the LS20 might. In which case there might be an advantage to create whatever ratio interested in using an LS20. But I could be totally wrong and misinterpreted "it can make sense to have your fixed interest securities in the ISA as they can claim back the tax paid on the distributions."

Maybe it just means not to have LS 100 in an ISA but any of the others are ok to qualify for tax refund?

masonic

bluebell321 wrote: »

That's why I posed my question. Only LS20 pays interest instead of dividends. If I understood the previous poster correctly, the other LS options might not allow refund of tax within an ISA whereas the LS20 might. In which case there might be an advantage to create whatever ratio interested in using an LS20. But I could be totally wrong and misinterpreted "it can make sense to have your fixed interest securities in the ISA as they can claim back the tax paid on the distributions."

Maybe it just means not to have LS 100 in an ISA but any of the others are ok to qualify for tax refund?

No income tax is deducted from distributions that are paid as dividends, regardless of whether a fraction of the income was received as interest.

Eco_Miser

bluebell321 wrote: »

That's why I posed my question. Only LS20 pays interest instead of dividends. If I understood the previous poster correctly, the other LS options might not allow refund of tax within an ISA whereas the LS20 might.

Distributions of interest, such as from the LS20, have 20% tax deducted at source, the ISA manager will reclaim this. Distributions of dividends, such as the other LS funds, have no tax deducted at source, so no tax to reclaim.

bluebell321 wrote: »

In which case there might be an advantage to create whatever ratio interested in using an LS20.

There might be. It's not a view I've seen expressed before.

bluebell321 wrote: »

But I could be totally wrong and misinterpreted "it can make sense to have your fixed interest securities in the ISA as they can claim back the tax paid on the distributions."

Maybe it just means not to have LS 100 in an ISA but any of the others are ok to qualify for tax refund?

Despite not getting a tax refund, there are still advantages to holding all your funds in an ISA, as Dunstonh said. These are protection from capital gains tax, and no tax paperwork and record keeping to do. See http://monevator.com/get-an-isa-life/ for gory details.

bowlhead99

As the others have said, if you have ISA space, put all your funds into it, avoiding all tax on interest, all tax on dividends, all tax on capital gains.

If you are short on ISA space, you have two choices. I will just do this example assuming UK funds are investing into UK companies and using the simplest transactions possible as taxation is complex and I can't be bothered with a billion caveats.

• OPTION 1) Put interest paying funds into the wrapper and dividend paying funds outside the wrappers and benefit from the inherent efficiency of the structure:

Inside your wrapper:
- bond fund invests £100 million;
- bond fund receives interest from companies of £4 million;
- fund pays operating expenses of £1m and interest expense of £3m leaving no taxable profits. Fund pays tax of zero;
- tax withheld at source and reclaimed by ISA manager leaving investors receiving all the £3m interest distribution.

Outside your wrapper:
- equities fund invests £100 million;
- equities fund receives dividends from companies of £4m and unrealised capital gains of £4 m as they increase in value;
- fund pays operating expenses of £1m leaving net profits of £7m. The profit is made up of dividends which are not not taxable, and unrealised capital gains which are not taxable hence no taxable profits. Fund pays tax of zero and distributes the £3m net income as a dividend;
- investor receives £3m which will result in a £0 tax bill for basic taxpayer, 25% (£0.75m) tax bill for high rate taxpayer and stores up £4m unrealised capital gains which will hopefully be manageable within annual exemptions but will be taxable at 18% or 28% for basic or higher taxpayers for any amount over the exemption which they choose to - or are forced by circumstance- to cash in during any tax year. So potentially a further expense of £0.72m for basic rate taxpayer or £1.12m for higher rate taxpayer.

As a result the total return to the investor is £3 ISA growth and £6.28-£7 (basic rate) or £5.13-£6.25 (high rate tax) outside the ISA. If a low rate taxpayer who can manage their capital gains, you can end up with £10 growth in your net worth, and £9.28 if you can't; if a high rate taxpayer, bestcase scenario is £9.25 overall return, worst is £8.13 with poor CGT planning.

• OPTION 2) Put dividend-paying, capital growth-achieving equities funds in ISA and interest-paying funds outside the wrapper

Inside your wrapper:
Equities fund distributes you £3m, absolutely tax free. Unrealised gains of £4m, will never be a problem.

Outside your wrapper:
Bond fund distributes you £3m. Taxed at source 20% (£0.6m). Higher rate taxpayer pays a further 20% (£0.6m).

As a result the total return to the investor is £7 ISA growth and £1.8-2.4m outside the ISA. If a basic rate taxpayer, best you can end up with is £9.4 growth in your net worth, which is very much towards the bottom end of what you might have got in Option 1 and well below what you'd get with good CGT planning; if a high rate taxpayer, best you can end up with is £8.8 which again is significantly below the max return that would have been available the other way around, although is a little better than if you had been paying full CGT.

Conclusion:
The traditional advice is that OPTION 1 is the best. As a basic rate taxpayer (BRT) you have up to £0.6 more net worth (£10 instead of £9.4). As a high rate taxpayer you have up to £0.45 more net worth (£9.25 instead of £8.8) by following Option 1, although if you are not very good with your CGT planning and were going to end up at only £8.13 you might actually be better off following option 2 and taking the £8.8; but that seems like a waste, because it is rare that someone would be paying 28% tax on every penny of their gains, so not a very meaningful comparison.

However there is perhaps a counterpoint to that traditional advice. By following Option 2 you have lower net worth (HRT 0.45 lower, BRT 0.6 lower) ; but your ISA wrapper is £4 smaller with Option 1 - the bond fund only grew your ISA wrapper by £3 instead of £7. Some years will deliver more than others but it is normal to presume that over the long term, the equities will be growing faster than the bonds.

So, what is the value of having an ISA wrapper that's £4 bigger? Well, if you are the kind of person who cannot max out your ISAs every year, it has no value at all. You don't need a bigger wrapper.

However, if you are the kind of person who is having trouble fitting assets into a wrapper, which is the only kind of person who is making the decision between 1 and 2, it could be quite valuable. This is because whether you are using it for bond funds, or cash, or equities funds (latter only really of use for a high rate taxpayer or CGT payer)... the ability to shield more gains is a good thing.

Let's say you have a £4 bigger wrapper. You might be getting returns at 5% (£0.2) a year on that. And if your tax rate is 20% or 40%, you would have been paying £0.04 or £0.08 a year on it. So the existence of the bigger wrapper which you created by putting your highest performing funds in the ISA in the first place (instead of your safest bond funds) has an annuity value of 0.04 to 0.08.

So as a high rate taxpayer 'taking the hit' of paying £0.45 extra tax this year by holding the bond fund outside the wrapper, you get £4 extra ISA wrapper which gives you an additional ongoing tax saving benefit of £0.08 a year. After six years your tax savings from having a bigger wrapper that would not otherwise have been available to you, will recoup the £0.45 and after a decade or two you could be quids in. Especially given that the £0.45 cost of holding your bonds outside an ISA as a high rate taxpayer was not the full story, and we mentioned that actually they might not have been any better off at all with bonds inside the ISA if they had a CGT problem on the higher-growing equities funds.

For basic rate payers it's more clear cut because it would take them well more than a decade for the annual tax savings from the bigger wrapper, at only £0.04 a year if that, to catch up their year 1 tax hit of £0.6

So, that's the science behind the general advice in post 2 to put bond funds in a wrapper and equities funds outside, which is not always best for everyone but is a great rule of thumb. But what about the question on the efficiency or inefficiency of having a VLS 20 plus a VLS 100 instead of a VLS 60? I've written all the stuff above and still not touched on it. But it is important to understand the theory first. If you're happy with that we can go on....

OK, so let's assume we are investing in an ISA and just want to look at lifestyling a VLS 100 down to 50% equities. To keep it simple lets say you are looking at VLS 100 plus a theoretical VLS 0, versus a theoretical VLS 50.

100% equities fund
- equities fund invests £100 million;
- equities fund receives dividends from companies of £4m and unrealised capital gains of £4 m as they increase in value;
- fund pays operating expenses of £1m leaving net profits of £7m. The profit is made up of dividends which are not taxable and unrealised capital gains which are not taxable hence no taxable profits. Fund pays tax of zero and distributes the £3m net income as a dividend.
- the investors receive the £3m as a dividend with no tax to pay as it's in an ISA, and is sitting on a £4m increase in value.

0% equities fund invests £100 million in bonds;
- bond fund receives interest from companies of £4 million;
- fund pays operating expenses of £1m and interest expense of £3m leaving no taxable profits. Fund pays tax of zero;
- the investors receive the £3m as an interest distribution, tax withheld at source but quickly reclaimed by ISA manager leaving investors receiving all the £3m interest distribution.

If you held half and half VLS 100 and VLS 0 in an ISA you would get an average of the two results: 1.5m dividends, 1.5m interest distribution, 2m capital gains, total £5m, no tax bill.

Then look at a VLS 50
- fund invests £50m in equities, £50m in bonds;
- receives dividends from companies of £2m and unrealised capital gains of £2m as they increase in value;
- receives interest from companies of £2 million;
- fund pays operating expenses of £1m leaving net profits of £5m. The profit is made up of dividends which are not taxable and unrealised capital gains which are not taxable and also interest which IS taxable. The fund is not making an interest distribution to investors hence it will not have an interest expense to reduce its profits. As a result of the excess of taxable interest income over its operating expenses, it will have some non-zero amount of taxable profits, and will pay a tax bill. The fund is now left with LESS than £5m;
- the fund distributes the [less than £5m] to investors as a dividend;
- the investors receive the [less than £5m] as a dividend with no tax to pay as it's in an ISA.

The mixed asset fund produced a sub-optimal result for the ISA investor as there was some tax leakage.

So, this would lead you to use the VLS 100 + the VLS 0, if available.

Actually, they are not. You could use a VLS20 plus a VLS80 to produce a pseudo-VLS50 or VLS60 though, depending on ratio of how you mix them.

However, the VLS 20 does not use a full suite of regional equities funds. It uses simply a UK and an world-ex-UK fund to do the job because there are not many equities anyway. Likewise perhaps the VLS 80 does not use many different types of clever bond funds, because it doesn't have much of a focus on bonds.

So when you mix the 80 and the 20 you do not get the exact same blend as a 60 you bought off the shelf.

HTH

bluebell321

Bowlhead99, you are incredibly generous with both your time and knowledge. Thank you. I will come back to read this properly.

Edit- yes, I understand now. Thanks again.

masonic

bowlhead99 wrote: »

Then look at a VLS 50
- fund invests £50m in equities, £50m in bonds;
- receives dividends from companies of £2m and unrealised capital gains of £2m as they increase in value;
- receives interest from companies of £2 million;
- fund pays operating expenses of £1m leaving net profits of £5m. The profit is made up of dividends which are not not taxable and unrealised capital gains which are not taxable and also interest which IS taxable. The fund is not making an interest distribution to investors hence it will not have an interest expense to reduce its profits. As a result of the excess of taxable interest income over its operating expenses, it will have some non-zero amount of taxable profits, and will pay a tax bill. The fund is now left with LESS than £5m;
- the fund distributes the [less than £5m] to investors as a dividend;
- the investors receive the [less than £5m] as a dividend with no tax to pay as it's in an ISA.

The mixed asset fund produced a sub-optimal result for the ISA investor as there was some tax leakage.

I guess this is true for many funds such as Vanguard's, which are domiciled in the UK. The exceptions would be investment companies domiciled in places where they are exempt from corporate income tax or pay it at a rate of 0%.

bowlhead99

masonic wrote: »

I guess this is true for many funds such as Vanguard's, which are domiciled in the UK. The exceptions would be investment companies domiciled in places where they are exempt from corporate income tax or pay it at a rate of 0%.

Absolutely, as I mentioned this isn't supposed to be a full guide to international taxation

Most investment companies will domicile themselves in locations which are tax neutral for their investors unless those jurisdictions create more problems than they solve (which they can, for some asset classes). Offshore companies which the media will criticise as being evil taking money out of our economy, are basically just having those residences specifically to be able to invest money back into our economy while avoiding unnecessary tax and deliver a neutral result for their taxpaying investors and taxpaying investee companies.

If you look at the annual financial statements for the VLS funds, rather than just the monthly factsheets, you can see in the footnotes that the 20% versions have no tax bills (because of large interest expenses when paying out to their investors, no remaining excess of income over operating expenses) and the 100% versions have no tax bills (because they don't pay tax on their dividend income, so taxable income will not exceed operating expenses). But all the others pay some amount of tax, which will increase when interest rates rise and there's more cash flowing in excess of the funds' operating expenses.

So, if you choose a version other than pure equities or pure bonds, you might find there's tax leakage out of your control - even if you think you've optimised your personal investment holding structure by using ISA or pension wrappers. This doesn't mean the tax cost of the convenience is not worth it ; just something to be aware of if you're a details person.