They say two things are certain in life, death and taxes. Thankfully, at least when it comes to the latter, we are able to reduce the amount of tax we may need to pay by making the most of our tax-free allowances!
There are a number of tax-free allowances that we can use when it comes to earning money and investing money. In this article we are going to talk through some of the key allowances available to you every tax year:
NB: tax-free allowances can and do change with each tax year (April - March).
This isn’t what your parents used to give you at the weekends, this is something that HMRC give us each tax year! Most people are familiar with income tax, as that’s what we pay when we earn some money. But, we only start paying income tax once we have used up our ‘personal allowance’. Each tax year, which runs from 6 April - 5 April, we receive a tax-free personal allowance. This is currently £12,570 and means we pay no income tax on the first £12,570 that we earn each tax year.
If you start to earn more than this then you will then begin paying income tax, where the income tax rate bands range from 20-45%. The average UK salary is around £31,000. This means, for the average person, tax is only paid on £18,430 worth of earnings as we pay no tax on the first £12,570 worth of earnings.
This is the main income-related tax allowance that we need to be aware of. Luckily for us when it comes to investing there are also allowances we can utilise, specifically the capital gains tax allowance and the dividend allowance.
Now to get onto the real fun - investing allowances! Before we dig into these investing allowances a bit deeper it’s worth mentioning ISAs and pensions. ISAs and pensions are types of account that we can use to invest. They work differently but both have built in tax advantages. With an ISA, we pay no tax any gains or dividends. With a pension, although we pay tax in the future we are able to avoid some tax today as contributions are made from our gross pay, before we pay income tax.
Each tax year we receive a £20,000 ISA allowance and £40,000 pension allowance. As a rule of thumb these should be prioritised before we start to use the third type of account, a general investment account (GIA). But, of course, many people have general investment accounts. For example, we can’t invest into crypto using an ISA or pension so we have to use a GIA.
A general investment account or GIA is another type of account that we can use to invest. Wombat offer a general investment account, along with a Stocks & Shares ISA. As mentioned above, these accounts don’t have any built in tax advantages but we are able to utilise the capital gains tax and dividend tax allowances when using these type of accounts.
When you go to the gym, ‘gains’ refers to when you put on some muscle, and when you invest, ‘capital gains’ are when your investments increase in value! Each tax year we get a capital gains tax (CGT) allowance. For the current tax year this is £12,300. This means that we can make £12,300 worth of gains, outside of an ISA or pension, and pay absolutely nothing in capital gains tax. It’s worth noting that you only pay CGT when you sell an investment, so if you never sell then you’ll never pay CGT.
It is also possible to spread your sale, if you have very large gains, over a number of years to make use of the full allowance each tax year. This is a brilliant, and very large, allowance. Realistically, unless you’re an investing prodigy making huge gains, you would need a very large portfolio at most likely six figures plus to make gains of £12,300 and pay any capital gains tax. Let’s say you use a Wombat general investment account and invest into Apple shares. Apple is up roughly 35% over the last year. If you wanted to, you could sell your gains before the end of the tax year and make use of the CGT allowance.
Who doesn’t love dividends? Free money for simply holding onto a stock or fund! Each tax year we also get a dividend allowance. For the current tax year this is £2,000. This means that we receive £2,000 worth of dividends, outside of an ISA or pension, and pay absolutely nothing in dividend tax. A lot of companies pay dividends and most funds pay dividends.
For example, using Wombat we can invest into Apple. Apple currently has a dividend yield of 0.54%, this means you would receive roughly $0.22 in dividends per yield. This means that just by holding Apple shares, not only have you enjoyed some great 35% gains over the last year, but you’ve also been earning some dividends. Win-win! This is another brilliant, and very large, allowance. Once again, you would need a very large portfolio at most likely six figures plus to receive dividends of £2,000 and pay any dividend tax.
Dividend yields can vary between companies and funds, but as an example global funds pay a dividend of roughly 1.5%. To receive £2,000 in dividends you would need a portfolio size of £130,000+. Although it’s worth saying that some funds pay higher dividends.
Over the last 100+ years the average dividend yield of the S&P 500, the largest 500 US stocks, is 4.29%. At this dividend yield, to receive £2,000 in dividends, you would need a much smaller portfolio at £47,000. The more of this dividend allowance that we are able to use each year, the better. Because if we don’t use it - the same with each of these allowances - we lose it as the allowances do not roll over into the next tax year,
We’ve spoken about income and investing, but what about saving? Well, guess what, we also get a saving or ‘interest earned’ allowance. So don’t keep that cash under your mattress, get it into a savings account and earn some tax-free interest! Each year we are able to earn some interest from our savings and pay no tax. The exact interest earned allowance you get depends on your income tax band:
It’s worth saying that savings rates are incredibly low. Even at 1% interest you would need £100,000 in savings to earn £1,000 in interest. Most savings accounts offer even less interest in reality (which is why starting to invest is key as we can earn higher rates of return!), so you would need even more in savings to reach the £1,000 allowance. For most people, due to the current low interest rates environment, there’s no danger of earning more in interest than the interest earned allowance. But it’s still another important allowance to try to use up and be aware of!
Make use of these tax-free allowances! Seemingly everything is going up. The cost of living, inflation, interest rates, taxes, and so on. The more we can make use of these tax-free allowances, the less we will pay in tax and the more money we keep in our own pockets. Over the course of our lifetimes if we’re able to utilise the ISA allowance, pension allowance, and the capital gains tax and dividend allowance when it comes to using a general investment account, then we will be going a long way to reducing our tax bill.