Reducing my tax rate

Posted on by FIRE v London

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 it is 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!)

 

 

29 thoughts on “Reducing my tax rate”

  1. 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

    1. 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?

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      1. 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. 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

    1. 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.

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  3. 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

    1. 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?

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  4. 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. 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. 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. 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

  8. Hi. Interesting article as are the others particularly with the uk focus. Do you or your readers have a view as to appropriate investments to take advantage of the annual cgt limits. I am primarily thinking of equity investments that do not pay a dividend – one obvious one being Berkshire Hathaway. Keen not to pay significant costs or invest in a sub-optimal instrument so that the tax saving is outweighed by poor investment performance. Half wonder if I shouldn’t just invest further in a global index fund and pay the dividend tax but doesn’t feel efficient. Not keen on VCT or EIS due to the very high charges that seem to strip out the gains plus the flood of money into these strategies is never a great signal for future performance. Any thoughts most welcome. Best

    Liked by 1 person

    1. @Seekingfire – thanks for your comment! Optimising for CGT is a common objective but hard to do reliably. I agree with you re VCT/EIS so far as funds go, and doing individual investments is a different ballgame.

      If you are up for US objectives then I would leaning towards Berkshire Hathaway, Amazon, Google, and perhaps Facebook.

      From a UK perspective there isn’t much like that. For the brave, ASOS/Fevertree. Perhaps Scottish Mortgage. Otherwise I’m afraid I’m coming up a bit blank!

      Like

      1. That’s ok and thanks for the reply. I am subscribing to the philosophy that you can’t successfully stock pick (at least I cannot!) so I limit myself to funds with a clear preference for passive funds or low cost investment trusts. There are a few investment trusts that do not pay dividends but I am not confident on their prospects or their fees are high. The answer is probably just to continue with passive funds such as the vanguard life strategy 100 and reluctantly pay the tax on the dividends. Thanks

        Liked by 1 person

      2. Scottish Mortgage has a strong track record and, if I remember correctly barely pays dividends. And its fees aren’t excessive. Worth a look.

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  9. How do you fund your personal investment company?

    If you loan the company a sum of cash, it could presumably invest the money and gradually pay you back from investment income, having only paid corporation tax on it – and such loan repayments would be income/dividend tax-free.

    I expect it’s not that simple.. have you taken advice on this?

    Liked by 1 person

    1. The funds in to the company are a loan, yes. I have once taken principal back out – to fund The Dream Home – but broadly speaking I haven’t yet withdrawn any of this funding. The interest charge is low.

      I have had a bit of informal advice but nothing serious.

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      1. Thanks – I am considering the PIC/FIC approach for some longer-term investments and estate planning purposes. Fascinating stuff – love the site 🙂

        Liked by 1 person

  10. As my taxable portfolio grows, I’m also getting a bit concerned about taxes…ideally wanting more capital gains and less dividend income, which are both hard to predict in advance.

    Liked by 1 person

  11. The Scottish Mortgage Trust is an excellent suggestion I think. As you say a low TER and low dividend yield with the portfolio confirming it is orientated towards capital growth as opposed to a regular income.

    The issue, which perhaps has been shown by the volatility over the last couple of dates, is that US markets seem relatively highly valued, and therefore query if it’s the right geography to over invest at this stage. Ideally there would be a trust with a low TER, focussed on growth invested in areas of low CAPE (e.g. parts of Europe, emerging markets).

    Liked by 1 person

  12. Hi FvL,

    Ah, a post after my own heart! Interesting to hear about your friend paying more in fees than he would have in tax – something to definitely consider.

    I’m focusing on filling both of our ISAs, my pension, upping a bit of cash, and overpaying the mortgage. No small order, but means all investments are as tax efficient as possible, and the mortgage comes down.

    The Offshore bonds are something I may look at next – I haven’t yet looked at the costs of this, will keep you posted when I do! Before I do I am actually more looking at what unsheltered I can take advantage of – build up something that I can utilise the Capital Gains allowance, my problem is that most ETFs pay income (which I want to avoid) and ACC funds apparenly still attract income tax 😦

    I dont consider myself “wealthy enough” for a PIC given my short time horizon before I want to start accessing things.

    I really struggle with the higher tax rate whilst I am earning as I lose so much, not just the 40 or 45% but also where it reduces items such as tax free allowance, pension allowance etc.
    Whilst I earn I want my investments to be as tax free as possible – which is why I will soon have to do much more research on options to build up usage of my capital gains.

    The plus side is the Wine Cellar is showing a major increase (although not sure I could ever get to sell some of them), and as a wasting asset no tax if I could ever bring myself to sell!

    Cheers,
    FiL

    Liked by 1 person

  13. hi there,
    very interesting piece, in your article you said ” 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”
    I’m I right in thinking the 250K is per person outside ISA/SIPP? i.e 500K per couple. the reason I ask is I started general investment accounts for my partner and myself with vanguard after filling up our ISA/SIPP accounts. I am in the awkward position of my SIPP contribution is limited by the yearly/lifetime allowance and my wife’s SIPP is limited by her small earnings.

    Best regards

    JC

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  17. Very interesting. I am considering a PIC myself and have a couple of questions. I am at a point where I think it makes sense to have a PIC as I am fully utilising all allowances and getting taxed at 38.1% on unsheltered divs over £2k, but not at the point where it makes sense to pay for advice as any benefits would be outweighed by the cost.

    The way I see it, a PIC would make sense for div tax deferral until a point where I am at a lower tax bracket. But it has a disadvantage when it comes to CGT, as a) I came take advantage of the annual allowance and b) any gains would be double taxed, first inside the company and then at a personal level when eventually extracted, for a combined rate much higher than the personal CGT rate of 20%.
    One solution may be to use it for high yielding holdings only. I would be interested to know how you have structured it.

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    1. you are thinking about it at least as carefully as I did!

      For me I think of my PIC as incremental to a bunch of ISAs/SIPPs and unsheltered assets. So I assume my unsheltered assets max out my CGT allowance and tip me into high tax bands. This point the PIC is helping me.

      The key logic here is that paying <=20% income tax 'on the way up', followed by ~40% 'on the way out', as considerably better than ~40% 'on the way up'.

      I historically haven't paid much CGT but your point about potential double taxation (on CGT as company profits in PIC, and then on withdrawals as dividends/similar secondly) is an interesting point I hadn't considered before.

      One big win for the PIC is that margin loans are tax deductible. I don't optimise for this yet but I will do over time. You do need to use a broker who supports Ltd company accounts and margin loans of course.

      I don't restrict my PIC holdings to particular asset classes (e.g. high yield).

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      1. Personally I don’t plan to use leverage. If anything I have negative leverage right now as I own bonds and cash, so before I borrow, I would reduce these to zero first. But I agree that if I were to use leverage, it is much preferable to do so within a PIC.

        “The key logic here is that paying <=20% income tax 'on the way up', followed by ~40% 'on the way out', as considerably better than ~40% 'on the way up'."
        Yes, unless in the way out in the former case it's 40% on the already taxed amounts. In that case it's considerably worse. It's even worse if there are significant capital gains, taxed inside the PIC at say 17% with no indexation relief, and then the proceeds taxed again at dividend rates, compared to taxed once at 20% in a personal account.

        Finally, legislation risk is another key issue. Check this thread here, especially the final answer toward the bottom.

        Personal Investment Company questions from UKPersonalFinance

        What are your thoughts on this new, apparently untested, legislation?

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      2. @Greektaxpayer – Re the new legislation. I think the bit of potential relevance is re Moneyboxes, i.e. not using PICs to stash cash and then distribute out as CGT. I don’t think it applies to me too much. I don’t foresee trying to get much out of the PIC during my lifetime and if at that point I have to pay income tax then so be it. In the meantime i can extract quite a bit into Mrs FvL’s SIPP without tax consequence.

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