What are tax-free and tax-efficient investments? | SavvyWoman

How to profit from tax-free and tax-efficient investments

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Some investments pay a return or profit without you having to pay on it. Others are tax efficient, and some investments generate a return that you have to pay tax on. What’s the difference between tax-free and tax-efficient investments, and how do these investments work?

Tax-free returns

Cash ISAs pay interest tax free (no matter how much you have in an ISA).

  • The interest you receive is tax free. When you save in a cash ISA (sometimes called a NISA or new ISA), any interest you get is paid without the tax being taken off. From April 6th 2016, all savings accounts will pay interest without the tax having been paid off. However, only the first £1,000 of interest is tax free, if you’re a basic rate taxpayer or £500 if you’re a higher rate taxpayer.

SAVVY TIP: Be aware that some banks and building societies pay less on cash ISAs compared to ordinary savings accounts (particularly on fixed rates). That means it’s well worth doing the maths before you decide to put your money into a cash ISA, especially if you’re a basic rate taxpayer.

You can compare cash ISAs and savings accounts at SavvyWoman’s best buy tables.

Tax-efficient returns

If you invest in a stocks and shares ISA, you don’t have to pay income tax or capital gains tax on any profits you make.

  • Stocks and shares ISAs sound like they’re tax free, but they’re described as ‘tax efficient’, because some tax has already been paid by the fund itself. So, while you don’t have to pay any extra tax on a stocks and shares ISA, it’s not entirely free of tax.

SAVVY TIP: The tax has already been paid on dividends (which are basically income payments generated by shares, usually paid twice a year) and a 10% tax credit is applied. It effectively reduces the tax paid within the fund, but doesn’t mean they’re tax free.

Investments where you pay tax on the proceeds

The most popular types of pooled fund are unit trusts and OEICS (which stands for open ended investment company). Here you pay tax on the profit you make. There are different ways you may have to pay tax:

  • You may have to pay tax on dividend income you receive, depending on the rate at which you pay tax.

SAVVY TIP: Everyone gets an allowance of £2,000 of dividend income which they can receive free of tax. Any dividend income you receive above this is taxed.  You can read more about dividends in my article called Understanding dividends and how they can increase your return.

  • You may have to pay capital gains tax. If you make a profit when you sell your holding in a unit trust or OEIC, you could be liable for capital gains tax, which is currently charged at 10% for basic rate taxpayers (or 18% if you’re selling a second property) or 20% if you’re a higher rate taxpayer (or 28% if you’re selling a second property)

SAVVY TIP: The reason that you may not have to pay capital gains tax (CGT) is that every year you get a CGT allowance, which is £12,000 in the tax year 2019-20. If you make less profit than £12,000 during the tax year, you wouldn’t have to pay capital gains tax, and even if you made more than this there are certain costs that you would be able offset against your profits to reduce your capital gains tax bill. You can read more about capital gains tax in my article called Capital gains tax when you sell investments.

Investment bonds – how they are taxed

Investment bonds are medium to long term products, although they don’t always have a specific term. Some can be designed to last for the whole of your life. They can invest in a wide range of assets, from shares to bonds, property and cash. They also contain some life insurance.

  • You don’t pay basic rate income tax or capital gains tax on the proceeds when you cash them in (as the insurance company running the bond pays the tax on the fund).
  • You can withdraw up to 5% a year from your bond without paying tax at the time, even if you’re a higher rate taxpayer.
  • If you’re a 40% taxpayer and you take out more than 5%, you have to pay the difference between basic and 40% tax on it.
  • You have to pay tax when you cash the bond in. These bonds aren’t tax free as any money you’ve taken out during the term of the bond is added to your profit and you have to pay income tax on the whole lot when you cash it in.

Related articles

How to transfer a cash ISA

Understanding the differences between saving and investing

Understanding risk in retirement

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