Reducing my tax rate

Avoiding tax is probably the best-known investment advice, and the mission that unites even the least sophisticated investors with the most financially literate.

How the government wants you to avoid paying tax

As a wise blogger (SHMD, I think it was, but I can’t find the link) pointed out recently, the UK offers unusually generous investing tax breaks (and that’s even before we get onto SEIS and EIS angel investing tax breaks).  There’s almost no point in calling Panama.

For most UK investors, the simplest way to avoid taxes involves two manoeuvres, each done annually:

  • Topping up your ISA(s). ISAs remain the biggest potential tax break in the UK, but they require multi-year patience; there is an annual ‘use it or lose it’ allowance so to maximise the benefits you need to act annually.  The limit these days is £20k per adult, so £40k per couple – which is a lot of money to find from disposable income but not enough to squirrel a large inheritance/windfall/25% pension drawdown away all in one go.
  • Making pension contributions. For most retail investors, pensions are a fairly straightforward tax break; in exchange for locking my money up until I’m c.60, I avoid any tax on the money from now until I start accessing it. For more affluent but nowhere-near-retirement-age investors, such as me, the UK policy is pretty crazy, because knowing whether your pot is going to breach the ceiling 20+ years out is a mad Monte Carlo guessing game.  A 30 year old expecting to retire at 70 and expecting annual returns of 7% should be careful about taking their pot above £60k.

It is worth stating the obvious that not only are these two manoeuvres both 100% legal but they are in fact actively encouraged by government policy.

Practically all the readers of this blog are at least higher rate tax payers – i.e. their marginal income tax rate is 40% or more.  For them the two key rates on offer are 40% and 0%.

For investors with smaller portfolios, which will be the majority of investors, practically all of their investments will be completely tax-free, and their investment tax rate is zero.  But for larger investors, this often isn’t the case – and there are more rates between these two extremes to consider too.

For many investors, the next trick is to split assets carefully between a couple.  The benefits of sharing assets have increased recently due to the fiddly allowances that the last UK finance minister, George Osborne, introduced. Each adult now gets their own individual annual interest income allowance (£1k for basic rate taxpayers), dividend allowance (£5k) and capital gain allowance (£11.3k).  Assuming a 4% dividend yield this means that approximately £250k of assets per couple can be held approximately tax-free, provided they are shared equally between them; this is a significant ‘marriage tax break’, even though it is never described as such.

For many couples, one person earns significantly less than the other. If this makes the lower earner a basic rate tax payer then his/her marginal tax rate is 20%. This is a significant tax saving versus the higher rate tax payer, even if it is only half the benefit compared to investing entirely tax free, and even allowing that it only works up to the point where the additional investment income pushes this taxpayer into the higher tax bands.  Roughly speaking a basic rate taxpayer has capacity, outside any tax shelter, to hold about £1m of investments.  A non-working partner, holding £1m, will save the couple about £20k of tax.

For most of us, none of the approaches described so far need any help from an IFA.  Pensions can be a bit of a tricky one but I will leave that as an exercise for the reader.

The next rungs on the tax-avoiding ladder

The moment you do talk to an adviser, trust me, tax is going to be a big topic of conversation.  A common approach peddled by any adviser I’ve spoken to, and adopted by a number of people I know including myself, is to stash funds in an Offshore Insurance Bond.  The core principles of such a bond are that you can take out, simplistically, 5% as income for 20 years tax-free, and the investment compounding within the bond is also tax-free.  What tends to be forgotten, if I remember correctly, is that a) there are significant fees involved with holding a bond, b) there are tax penalties for redeeming early, and c) any withdrawals beyond the 100% are then taxable as income tax.

Now we’re talking about for-fee tax-avoiding products, namely offshore bonds, we are moving onto a key investment minefield.  Where sophisticated investors start to part ways with weekend supplement readers is in understanding the vital importance of fees as well as taxes; it is crucial to consider both fees and taxes, and not make tax avoidance the overriding objective. I have one very smart, very rich friend (net worth $50m, self-made before the age of 40) who has structured his affairs offshore in such a way as to almost completely eliminate taxes, but pays higher fees to do so than the value of the (income) taxes he was trying to avoid.

One way to look at it, which the entire financial industry endeavours to avoid you doing, is to consider your annual fees as a tax on your annual investment income.  Annual charges of 1% on a portfolio yielding 3% are equivalent to a compulsory tax of 33% on your income – but this tax isn’t paying for schools and hospitals, it’s paying for your adviser’s cars and yachts! But I digress.

Now, where to put offshore bonds on the tax rate spectrum?  In my case, I consider the effective tax rate to be <10%.  This is because I plan to leave the bond compounding up as much as I can, and will only occasionally make withdrawals (which will be very tax-inefficient).  I also have fairly conservative holdings in my bond, with a higher income tilt than capital gain tilt, so the penalty for having to take all gains as income is not so severe.  For the purpose of this post, I’m considering my effective tax rate on this wrapper to be 5%.

The upper rungs of tax efficiency – Personal Investing Companies.

In the last few years, a new technique has become more popular – especially for high net worth investors – namely setting up a Personal Investment Company (PIC).  The key rationale here is that UK corporation tax is under 20%.  There is a fixed cost of owning and administering a PIC but provided the company has enough assets then for higher rate taxpayers the tax savings can be significant.  Other factors to consider include inheritance planning, access to the funds over time, the benefits of dividend smoothing, your appetite for EIS investing, and the ability to offset legitimate expenses – especially interest costs.

For unrelated reasons I set up a Ltd company around 20 years ago. This company has now partially morphed into a small PIC, so I have some experience here. My annual running costs are around £3k (though it can be done for less), so ignoring any deductions I am winning with investable assets of over about £20k. My PIC portfolio, though small, is large enough for me to consider the applicable marginal tax rate to be 20% (i.e. to roughly ignore the admin/running costs).

This PIC has a margin account with Interactive Brokers and I track its (fairly small) portfolio as an integrated whole with my (considerably larger) personal portfolio.  Right now I am very underleveraged here (which I will expand more upon in an upcoming blog post about leverage).

Optimising my investment tax rate

My investment portfolio, worth several million pounds, is too big to shelter completely from tax very easily.  But it certainly isn’t arranged yet as efficiently as it could be. So over the last few years I’ve gradually been improving its tax efficiency. Here’s what I’ve been doing:

  • ISAs: To the maxx. I love ISAs.  And £40k per year, between me and Mrs FvL, is meaningful.  We’ve been topping up the maximum possible, right at the start of the tax year, for each of the last few years.  I’m shifting funds from my private banking portfolio to do this.
  • Pensions: Topping up Mrs FvL’s pension. My pension is probably going to hit the government’s lifetime limit without further topups.  But Mrs FvL’s is a lot smaller, and as a basic rate taxpayer she can still contribute up to £40k or 100% of her earnings.    I am not such a fan of pensions to want to max out her contributions but we’ve been contributing £10k-£20k per year in recent times.
  • PIC: Slowly hoarding assets here. I don’t take any dividends or salary from my PIC, I just let the assets compound up. I’ve had some trading profits this year and they are all being invested in my PIC’s portfolio.
  • Mrs FvL: Gradually shifting assets into her name. For some reason I have been drip-feeding funds into Mrs FvL, as they become available – with hindsight I should have moved faster here.  She remains a basic rate taxpayer, but only just.
  • Offshore bond: not touched. I have a small offshore bond.  If it awkward to manage, and I’m not sure the tax advantages are worth the hassle.  So I leave this one alone – I don’t plan to top it up but I don’t plan to unwind it either.
  • Private banking portfolio: spending the capital. Right now, though I’m roughly living within my means, I don’t spend the income in the place where I get it.  So any income that comes in to the PIC gets saved.  And instead I spend the savings I’ve got in my high tax, high fee pot – my private bank pot.

I’ve said before that I don’t have much to complain about personally from UK taxes.  SHMD is right, that the UK treats me probably better than almost anywhere.

When I started tracking my portfolio five years ago, my blended investment tax rate was 33.6%.  I had over 50% of my money in tax-inefficient private banking portfolios. I had 20% in an unsheltered execution-only retail broker. I had a small offshore bond, and nothing in a PIC.  And at the start of 2013, Mrs FvL and I had only around £500k in tax-free ISAs/pensions.

As I finish 2017, five years later, there have been many changes.  My overall portfolio hasn’t changed much in size, despite healthy returns, because I spent (invested? No, spent) a lot of it on a Dream Home.

At this point my private banking assets amount to 40% of the assets (and in fact closer to a third, net of a margin loan).  I now effectively have a PIC, albeit with less than 10% of my assets. My offshore bond has shrunk slightly, reflecting how I ravaged it to buy the Dream Home.   Mrs FvL’s portfolio has expanded so is as now as large as it was before we bought the Dream Home.  But the big improvement is that I now have significantly over £1m across my and Mrs FvL’s ISA/pension accounts.

As a result of these changes, my blended investment tax rate has fallen to 30.0%, meaning that I have cut my tax exposure by about a tenth over five years. Further improvements will be harder but I think I can get the rate down below 30% and keep it there.

2017 12 FIREvLondon tax mix

(Note: This post ignores the additional tax rate of 45% which applies to income of over £150k p.a., and just assumes the max marginal rate is 40%.)

(Note: I’m also ignoring the new Scottish tax rates proposed this month! Bad luck, Scottish FIRE seekers!)

 

 

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11 Comments on “Reducing my tax rate”

  1. The Rhino says:

    Nice article – learned a few new things..

    TBH – recently I’m starting to think I may not want to necessarily reduce the tax I pay. News stories like the tax reforms in USA are starting to seem a little gross.

    I am pretty minimalistic on the tax front, my marginal rate is 3.9% at the moment (and thats lumping NICs and Income Tax together)

    Having recently had a positive NHS experience, I’m actually starting to feel a bit bad about it?

    Maybe Corbyn will also start to appeal in 2018?

    Its a funny old world?

    PS I definitely don’t like the idea of swapping taxes for fees on a like-for-like basis, thats awful.

    Liked by 1 person

    • Thank, Rhino, for the comment. I agree re taxes/NHS and maybe even one day about Corbyn!! Mrs FvL makes similar points; her effective income tax/NI rate is under 15pc and she earns more than the national average, even before you consider her portfolio.

      At a high level, how come your marginal rate is so low?

      Like

      • The Rhino says:

        Nothing clever about how I’ve got it so low – I’m salary sacrificing into a SIPP down to minimum wage.

        Liked by 1 person

  2. CyclingHedgie says:

    Interesting you don’t take income from the PIC. Just as an observation, while we have the £5k dividend allowance, depending on your shareholding structure it may be worth mopping up any unused allowance you have by having the PIC pay a small dividend. You can always just lend it straight back to the PIC, it’s pretty uncomplicated. Why would you want to do this? If / when you come to wind the PIC up, the smaller it’s net balance-sheet, the less taxing it’ll be.

    The other slight annoyance is the removal of the indexation allowance on gains for companies, in the long rune that makes a PIC a bit less tax efficient. May also be worth your PIC making pension contributions into your wife pension, if she’s a director or the company secretary. This is obviously an expense for the company so reduces it’s tax burden and shrinks the balance sheet a bit. Again you can lend it the money to do this (that might have otherwise gone into her pension).

    Liked by 1 person

    • I get plenty of divis from the rest of my unsheltered portfolio so am well above my £5k allowance.

      But yes I do make Mrs FvL’s SIPP contributions from the PIC.

      Interesting point about minimising the net balance sheet. As it’s quite small currently I haven’t looked too carefully into how I’d wind the PIC up but your comments are a good prompt to find out more. Thank you.

      Like

  3. CyclingHedgie says:

    Oh, actually, and a question: Who do you use to arrange your offshore bond? Is there a cost-sensible way of doing this?

    Liked by 1 person

    • My offshore bond was set up my an IFA a long time ago, with a firm now owned by Old Mutual. Fees are high. Can’t be the best way of doing this but I don’t know a better way.

      Any other readers know away to DIY such a bond with low fees?

      Like

  4. Slow Dad says:

    Thanks FvL, I learned a couple of things from your post.

    I need to read up some more on the mechanics behind operating a PIC, and how that may impact with semi-retirement.

    Liked by 1 person

  5. reckless saving says:

    My wage is below the higher tax bracket, previous tax year I had an unusually good investment income return that pushed me when including a portion of my dividend income into the higher bracket plus for the first time my taxable dividends also passed £5000 allowance mark. Was prepared to set aside the 32% dividend tax, late in the tax year got a small work bonus which I put in my pension to get the tax in there under salary sacrefice(SS), then light bulb moment that SS doesn’t increase my taxable income and that I could manage it to reduce my dividend tax bill – too late for that tax year though still have to pay 32%.

    So this year I’ve had a similar set of income streams but managed it better by putting more in my pension under salary sacrifice by tweaking the monthly percentages rather than additional one-offs so I also reduce my NI contributions to divert into pension. This will give me a buffer to cover the taxable dividend income so I don’t cross into the higher tax bracket, so owe 7.5% instead of 32%. Only bit I messed up on this year was I got my dates wrong on when my employers cut-off dates were for changing my pension percentage, will being having to put some extra in my pension for one more month than I had planned.

    Liked by 1 person

  6. John B says:

    At the other end if the scale, having been FIRE for a year, I suddenly realised thst due to the odd way HMRC apply the Starting Rate for Savings that my tax rate this year would be 0, and a I’ve had to scramble to cancel all my gift aid declarations. A nice problem to have!

    Liked by 1 person

  7. David L says:

    First off, great posts and content – noticed your blog a few weeks ago and trying to go through all the content. I found this post particularly interesting. Taxes, a subject that typically could be considered boring, can have such big impact on your NW for the long term depending on how you structure it. I was very interested in the idea of a PIC – how did you go by setting one up? Are there any good guides in terms of steps and considerations when setting one up?

    Liked by 1 person


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