Simple ways to stay tax smart

What you’ll learn:

• How to protect your savings from income and Capital Gains Tax (CGT) charges.
• When the taxman will top-up your pension savings.
• Which tax breaks will cut the tax bills on your investments.

Savings and investments are subject to tax, which can have a big impact on your returns. The good news is there are plenty of ways you can bring your tax liabilities down by making sure you take advantage of the tax allowances the Government gives you each tax year. Many of these will be lost to you for good if they go unused by the end of the tax year on 5 April 2021, so it’s well worth exploring what’s available.

It’s important to remember, though, that tax rules can change in the future and their effects on you will depend on your individual circumstances. We don’t offer personal tax advice so you should seek independent financial advice if you’re unsure about anything.

Consider making the most of your ISA allowance

Each tax year you can invest or save a set amount into tax-efficient Individual Savings Accounts (ISAs). 

Find out more about our Investment ISA

In the 2020-21 tax year, you can put up to £20,000 into ISAs. You can split your allowance between a cash, investment, innovative finance and a lifetime ISA.¹ However, with a lifetime ISA, you can only pay in up to £4,000 of your £20,000 allowance. You can put money into one of each kind of ISA each tax year.

You won’t pay income tax, tax on dividends or interest distributions classed as savings income, or Capital Gains Tax (CGT) on any investments you hold in an ISA, so it may be worth considering using up your ISA allowance each tax year. If you invest outside an ISA, any profits made above the annual CGT allowance, which for the 2020-21 tax year is £12,300, are subject to tax at 10% or 20% depending on your tax band. When you invest in an ISA, even if the profit you make is above this £12,300 threshold, you won’t have to pay CGT.

Similarly, the first £2,000 of dividends earned from investments held outside an ISA are tax-free. This is known as the dividend allowance. If you exceed this threshold, you will be taxed at a rate of 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. Dividends received on shares held in an ISA are tax-free.

Changes to tax on interest earned outside an ISA, which came into effect on 6 April 2016, may influence the decision for many on whether to hold cash inside or outside of an ISA. Basic rate tax payers now have an annual tax-free personal savings allowance of £1,000 and higher rate tax payers a £500 allowance, which could see ISAs only being attractive for those with savings income in excess of these allowances. Additional rate tax payers don’t have a personal savings allowance.

Even if you have no income tax liability at the moment and large capital gains aren't likely any time soon, it's still worth thinking about holding your investments inside an ISA.

Building up your portfolio inside an ISA will shelter you from having to start paying tax on it later if your tax position changes because you are making larger gains or receiving more income. Remember that tax rules can and do alter over time, and the value of any favourable tax treatment to you will depend on your individual circumstances, which can also change.

If you don’t use your full allowance in the tax year, you can’t carry any unused allowances over into the next tax year.

However, ISAs (except for lifetime ISAs) are now more flexible than ever, so it is possible to withdraw cash from your ISA and put it back within the same tax year without this counting towards your ISA subscription limit for that year. Not all ISA providers may offer this flexibility though, so check with your provider before withdrawing any money. Good record-keeping of annual withdrawals and payments-in are strongly recommended.

Investment ISA holders can use existing assets to fund their ISAs and capitalise on their Capital Gains Tax (CGT) allowance using a technique known as ‘Bed & ISA’. To do this both accounts need to sit with the same provider. It works like this. You sell enough shares held outside your ISA to realise sufficient cash to fund your remaining ISA allowance. This money is then transferred into your investment ISA where the same shares are repurchased.

The sale and repurchase transactions are placed sequentially and so you are only “out of the market” for seconds, thereby minimizing the risk of a significant movement in the share price. By placing a “Bed & ISA” trade we take care of it for you, but you will crystallise any gains that you have made on your investment outside the ISA and this may result in a CGT liability, if you have already exceeded your allowance.

You can Bed & ISA an investment in funds as well – such as unit trusts, investment trusts and Exchange Traded Funds (ETFs). ETFs, like shares are transacted in quick succession. But, if you Bed & ISA funds the repurchase transaction is placed on the next dealing point, and so you would be open to a greater movement in price.

The Bed & ISA tax tool works particularly well for those with substantial shareholdings outside an ISA. With Barclays Smart Investor, while there will be no dealing charges to cover for either the sale or repurchase of the assets. You’ll have to pay government taxes, but you’ve successfully moved this portion of your investments into a tax shelter for future CGT savings.

Reduce your taxable income with a pension

ISAs offer favourable tax treatment once your money is in the account. But they don’t help you cut your immediate income tax bill, because your contributions still come out of taxable income. If you want to reduce the amount of today’s income that you’re losing to tax, you could consider paying into a pension, like a workplace pension for example, or a SIPP (Self-Invested Personal Pension).

When you make contributions to a pension you get tax relief from the Government. If you’re a basic rate taxpayer you’ll receive tax relief of 20% on your contributions, to the extent that you’re paying that much tax. So, if you pay £8,000 into a pension, you’ll get a further £2,000 added through tax relief. If you’re a higher rate taxpayer, you can reclaim up to an additional £2,000. In other words, you’d pay a net £6,000 out of your after-tax income (pay £8,000 but receive tax relief of £4,000 - £2,000 almost immediately and £2,000 via your tax return) and end up with £10,000 in your pension pot.

You can receive tax relief on up to £40,000 of pension contributions each year, or 100% of your earnings, whichever is lower. This includes all contributions you make into any pension plans, such as a company pension scheme and payments that an employer, or anyone else, makes for your benefit.

You can also carry forward unused allowances from the previous three years, as long as you belonged to a pension scheme during those years and your total contributions for the year do not exceed 100% of your income. Your total pension savings must also not exceed your Lifetime Allowance, which is £1,073,100 in the 2020-21 tax year.

The rules changed in April 2016 if your adjusted earnings are greater than £240,000. You now lose £1 of tax relief for every £2 you earn over £240,000, up to a maximum reduction of £36,000. This means if you earn £240,000 or more, your annual allowance will begin to drop, with those earning £312,000 or more receiving an allowance of £4,000. Adjusted income includes both personal and employer pension contributions.

The tapered reduction doesn’t apply to anyone with ‘threshold income’ of no more than £200,000. Threshold income excludes pension contributions. Your annual allowance will therefore only be reduced if both your ‘threshold income’ is above £200,000 and your ‘adjusted income’ is over £240,000.

So, for example, if you earn more than £200,000 and you and / or your employer contribute in total the full allowance of £40,000, you might be affected, as your adjusted income will be over £240,000, and your threshold income is over £200,000.

Also, anyone who has drawn more than their tax-free lump sum from their pension will have the amount that they can contribute to a pension reduced to £4,000 or 100% of earnings, whichever is lower, as their annual allowance is replaced by the Money Purchase Annual Allowance.

Bear in mind that with any pension, your money will be locked away until you reach the age of 55, which is 10 years prior to when you can draw your State Pension (this will rise to 57 by 2028). Also, when you’re able to access it again, most of it may have to be taken as taxable income.

Remember, tax rules can change and this could affect both your future opportunities and existing arrangements. Tax treatment depends on individual circumstances. You might want to get professional advice to help you become more tax-efficient with your investments.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change in future. Their effects on you will depend on your individual circumstances.