Holding mutual funds outside the ISA

NordicNoir

the_learner wrote: »

.....I guess the question is: can a fund distribute cash under both income and dividends? All the funds I saw on HL only have income or dividend as type of payment, never both.

Have a read of this:

https://www.pruadviser.co.uk/new_pdf_folder/bonds-and-oeics.PDF

....just the bit about how a fund decides if it pays interest or dividends....the other stuff is a bit out if date!

bowlhead99

Mixed asset funds are generally unable to stream their income payments into "a bit of interest, a bit of dividend".

Basically if over 60% of their assets used to produce the income are cash or other fixed-interest assets such as bonds, they will class themselves as a non-equity fund and characterise their distributions as interest. This can help to ensure that they do not suffer any tax internally, because they have a big interest expense (from paying their investors) to offset against the interest income they earned over the course of the year from their portfolio, and so they will hopefully get a zero tax bill for themselves and better performance.

But if 60% or less of their assets were in cash or fixed interest, they will just pay their taxes on the interest bit (if any) and the remaining residual income is paid over to their investors as a dividend.

So, most funds will reliably pay interest distributions to their investors from year to year OR dividend distributions from year to year to their investors - but will not be mixing it up without a publicised change in strategy, and they won't pay both interest and dividends within the same year. For you receiving those payments, you will therefore be able to use your dividend allowance or your personal savings allowance on the income allocated to you depending on whether it is dividends or interest.

In case the following is relevant to you: as Michelle said earlier, it's important to recognise that if you have bought the 'Accumulation' version of a fund, then the income (whether interest or dividends) which is allocated to you will not be physically sent to you. Instead, for administrative convenience, after allocating the income to you for the year (or six months, or quarter, however often they do it) they will just reinvest the arising income into new assets within the fund, and not actually distribute anything to you. That way, by not physically distributing any money to you, the fund asset value will stay as high as possible instead of dropping as money is put into your own hands. However, you still earned the income (whether interest or dividends) and so it is still your responsibility to pay tax on it even if you chose to buy the accumulation version where the income is left sitting inside the fund rather than being received into your own hands. If you chose 'income' or 'distribution' units instead of 'accumulation' units it is more straightforward because you can easily see when money is being paid over to you.

Once you have dealt with income (interest or dividend) side of things, the other side is capital gains tax. No tax is payable from year to year if you are not actually selling any of your shares/units. However, when you eventually you do sell a share of the fund you have to compare the cost (price you paid for it) with the proceeds (what you got when selling it). The cost is what you initially paid for the shares plus any money you reinvested along the way (including income/interest that was reinvested for you by the fund manager, in the case of Acc funds). Once you compare sale proceeds to cost, you may (hopefully) have a gain, and then if the overall gains you make in the year you sell exceeds your annual exemption, you will have some capital gains tax to pay.

So: depending on the type of fund, you may have dividend tax to pay on your dividend income plus CGT on sale (and both the dividend piece and CGT may be covered by your allowances and exemptions depending on the amounts involved) ; or you may have interest income tax to pay on your interest income plus CGT on sale (and both the interest and CGT may be covered by your allowances and exemptions depending on the amounts involved. But you are unlikely to get interest income AND dividend income in the same fund.

For completeness: if you branch out into real estate / property funds such as PAIFs and REITs you may encounter a third type of income - "property income distributions". This is the net income made from a direct property portfolio (rental income etc) and some types of funds are set up to stream it separately. That sort of income isn't covered by a dividend allowance or personal savings allowance because it isn't a corporate dividend and it isn't interest, it's just taxed at your normal marginal rate. Some PAIFs and REITs would pay you (or accumulate for you) a mix of PID and dividends at each periodic distribution point.

Neither of the two funds you mentioned will do that as they are not in the property game, but if you were to branch out to a varied portfolio with equity funds and bond funds and property funds, your overall returns will be a mix of income (dividends, interest or property income) and also CGT on disposal.

the_learner

Thank you all, I read with extreme interest. So given my current situation:

- taxable income likely to be above £100,000 for year 2017/18
- personal allowance reducing by £1 for every £2 more income I get

The best solution for me is to find a relatively stable fund that pays as dividends, since my £5,000 dividend allowamce is still unused (same fkr capital gain allowance). I guess I can only choose an absolute return fund for this, since it seems to pay dividend and have a volatility that is tipically lower than equity funds.

On the other end, I would pay 60% tax on any income a fund might distribute (40% marginal rate, plus the 20% as effect of reducing my personal allowance by £1 for every £2 income).

If the above is correct, there is still one issue.

Suppose my taxable income from job is £100,000. I pay a marginal income tax of 40% and my personal allowance is still intact at £11,500.
Now assume that my funds held outside the ISA pay £5,000 dividend.

Is this £5,000 actually tax free in my situation? The reason why I ask is because if the dividend will increase my total taxable income (at least for the purpose of computing the personal allowance) I will actually see my tax free area reduce by £2,500. The effect of all this, would be an actual 20% on £2,500 of my dividends, with only the remaining half being actually tax free.

Do you know if that is how it will work? Thanks again for all the clarifications.