Tax-efficient investing in the UK (or what order to put things into an ISA or SIPP)
Can’t fit all your investments into your ISAs and SIPPs? Then you’ll reduce your tax bill by following the first rule of tax-efficient investing:
Squeeze the most heavily taxed investments into your tax shelters first.
Happily, the pecking order for maximum tax efficiency is clear cut for most people.
Tax-efficient investing priority list
Shelter your assets in this order:
- Non-reporting offshore funds
- Bond funds
- Individual bonds
- Income-producing equities
- Foreign equities (arguable)
To see why this sequence is tax efficient, let’s just tee up the relevant tax rates:
|2022/23||Income tax||Dividend tax||Capital Gains Tax|
|Basic rate taxpayer||20%||7.5%||10%|
|Higher rate taxpayer||40%||32.5%||20%|
|Additional rate taxpayer||45%||38.1%||20%|
(Note: From 6 April 2023 the dividend tax allowance is halved to £1,000 and the CGT allowance is cut to £6,000. Also note, these capital gains tax rates are for investments like shares. Capital gains on residential property other than your own home are taxed at 18% and 28% instead of 10% and 20%.)
At a glance we can see that income tax is the nastiest while capital gains tax (CGT) is generally the most benign. Your CGT burden can also be reduced by offsetting gains against losses.
So the plan is to shelter investments that are liable to income tax first, dividend tax second, and CGT third.
A few tax efficiency caveats to consider
Before we get into the guts of it, I’ve got to dish up some caveat pie:
- Interest is taxed at your usual income tax rate. Basic-rate payers have a £1,000 personal savings allowance, reduced to £500 for higher-rate payers and nil pounds beyond that.
- A few very low earners qualify for an additional band of tax relief on savings. Up to £5,000 of interest can be sheltered under the ‘Starting Rate for Savings’.
- If your interest, dividend income, or capital gains pushes you into a higher tax band then you will pay a higher rate of tax on the protruding part.
- In that situation, it matters what order you’re taxed in, so you can make the most of your tax-free allowances. The UK order of taxation is: non-savings income, savings income, dividend income, and finally capital gains.
- If you’d like a quick refresher on the tax-deflecting powers of ISAs and SIPPs, just click on those links.
- And if you’re not sure which is best for saving then try our take on the ISA vs SIPP debate. Most people should probably diversify across both tax-efficient investing shelters. But there are a some important wrinkles to think about.
Let’s now look in more detail at – all things being equal – the best order of sheltering assets for tax-efficient investing, starting at the top.
Non-reporting offshore funds
Offshore funds that do not have reporting fund status are taxed on capital gains at income tax rates. And as you can see from the table above, that’s a hefty tax smackdown.
Worse still, your capital gains allowance and offsetting losses are knocked out of your hands by HMRC like the school bully taking your lollipop.
If your offshore fund or exchange-traded product (ETP) doesn’t trumpet its reporting status on its factsheet then it probably falls foul.
It’s worth double-checking HMRC’s list of reporting funds. Many offshore funds / ETPs available to UK investors don’t qualify. Also, it’s possible for a reporting fund to lose its special status.
Any fund that isn’t domiciled in the UK counts as an offshore fund. (Sometimes it’s worth saying the obvious!)
Bond funds and ETFs are next into the tax bunker because interest payments are taxed at income tax rates rather than as dividends.
Any vehicle that has over 60% of its assets in fixed income or cash at any point in its accounting year falls into this category.
However because bond distributions count as savings income, interest payments are also protected by your Personal Savings Allowance, so long as it lasts.
Bond fund capital gains fall under capital gains tax, naturally.
Bear in mind that recently-acquired bonds and bond funds will probably be paying out more interest now that yields have risen.
Starting Rate for Savings – bonus protection
Some people – most likely retirees – can find themselves with low earnings income but reasonable savings income.
Such savings income can be sheltered by the Starting Rate for Savings.
Savings income that sits in a £5,000 band beyond your Personal Allowance may qualify for a 0% rate of income tax thanks to the Starting Rate for Savings rules.
That’s most likely to happen if your non-savings income plus savings income lands somewhere between £12,570 and £17,570.
(The upper limit can be increased if you’re eligible for additional tax-free allowances.)
Beware that every pound you earn (in non-savings income) over £12,570 shaves £1 from your £5,000 Starting Rate for Savings allowance.
So if you earn over £17,570 in non-savings income then you won’t get any Starting Rate for Savings privileges.
Whereas, £14,000 in non-savings income leaves you with another £3,570 in savings income that can be protected using your Starting Rate for Savings.
Any savings income that can’t huddle behind the Starting Rate for Savings barricade can still duck under the Personal Savings Allowance.
All this begs the question: what counts as earnings income?
The main categories are:
- Income from work, whether employed or self-employed
- Pension withdrawals including the State Pension
- Retirement annuities
- Taxable benefits
It’s obviously less urgent to get all your bonds into your ISAs and SIPPs if you can earn interest tax-free via the Starting Rate for Savings and Personal Savings Allowance routes.
As mentioned though, bonds can make capital gains. Long to intermediate maturity bond funds are most likely to land you with a significant CGT bill.
Short bonds and money market funds typically achieve at most miserly capital gains.
Real Estate Investment Trusts (REITs)
REITs pay some of their distributions as Property Income Distributions (PIDs).
PIDs are taxed at income tax rates not as dividends.
Get them under cover for optimal tax-efficient investing.
Individual bonds are liable for income tax on interest – just like bond funds.
The only reason that bonds are slightly further down the list is because individual gilts and qualifying corporate bonds are not liable for capital gains tax.
We’ve previously delved into the differences between how bonds and bond funds are taxed.
The dividend tax situation has got a lot worse for UK investors in recent years, so high-yielding shares and funds should duck under your tax testudo next.
By all means prioritise protection for your growth shares if you think CGT is the bigger problem.
But bear in mind you can still defuse capital gains every year – although this mitigation measure is being steadily eroded by the shrinking capital gains allowance – and you can usually defer a sale.
It isn’t necessarily a priority to get overseas funds and equities sheltered, but there’s a tax-saving wrinkle here that only works with SIPPs.
The issue is withholding tax, which is levied by foreign tax services on dividends and interest you repatriate from abroad.
Sometimes withholding tax will be refunded as long as you fill in the right forms. For example a 30% tax chomp on distributions from US equities becomes a mere 15% if your broker has the appropriate paperwork.
Foreign investments in SIPPs can often have all withholding tax refunded but only if your broker is on the ball (and the appropriate agreements are in place). You’d need to check. ISAs don’t share this feature.
If you hold foreign equities outside of a tax shelter then you can use whatever withholding tax you have paid to reduce your UK dividend bill.
So in the case of US equities, a basic-rate taxpayer could use the 15% they’ve paid in the US to reduce their 7.5% HMRC liability to zero.
In other words, only higher-rate / additional-rate taxpayers should consider sheltering US equities in ISAs from a dividend perspective. (There’s still capital gains tax to think about in the long-term, remember.)
Everyone can benefit from the SIPP trick though.
It only remains to say that this is generalised guidance and tax is a byzantine affair. Please check your personal circumstances.
Tax efficiency is important but whatever happens don’t let the tax tail wag your investment dog.
Take it steady,
Note: This article on tax-efficient investing has been given a tidy up after a few years out in the pastures. Comments below might refer to previous tax rates and allowances. So do check the date they were posted!
Thanks for reading! Monevator is a simply spiffing blog about making, saving, and investing money. Please do check out some of the best articles or follow our posts via Facebook, Twitter, email or RSS.