Investors are facing a hefty tax burden right now thanks to the freeze on tax thresholds and allowances.
With further cuts to capital gains tax (CGT) looming, as well as more cuts to the dividend tax allowances, tax efficiency needs to be at the forefront of your mind.
These upcoming changes should serve as a wake-up call for both savers and investors. If you haven’t already invested through a tax-efficient wrapper, now is the time to do so. Tax-free individual savings accounts (ISAs) are a must-have when you consider cuts to the CGT and dividend allowances.
Why choose an ISA?
Under current rules, you can shelter up to £20,000 per tax year in an ISA, either in cash or investments (a stocks-and-shares ISA). This is appealing to taxpayers because all income and capital gains are tax-free. By moving your investments into one of these tax-free wrappers, you can protect future gains and dividends from the clutches of the taxman, thereby beating the CGT cut. And, once money is squirrelled away in an ISA, it remains protected year after year.
How has the CGT allowance changed?
For the second year in a row, the amount you can generate, tax-free, in capital gains, is being cut.
At the start of the 2023–24 tax year, the government cut the capital gains exemption from £12,300 to £6,000 and this limit is due to halve again from 6 April 2024, to just £3,000. This means you will only be able to make £3,000 worth of gains a year before you pay tax on them.
What does that mean if you’re looking to sell assets?
Those with assets to sell that are outside of a tax wrapper will use up their CGT exemption much more quickly. Any gains on investments not in an ISA above the tax-free limit will be subject to the tax. Gains are added to income, and if they fall in the basic-rate band are taxed at 10%. If they fall in the higher-rate tax band, they are taxed at 20%. If the gains are from a second property, a further 8% is added.
It’s therefore important to think about whether to cash in some gains this year, up to the annual limit, to avoid having to pay tax on them in future years.
Consider Bed and ISA
One approach you might want to look at is Bed and ISA. You can use this method to transfer assets (such as shares and funds) held outside a tax wrapper into an ISA, so that future investment growth and income are protected from tax.
First, you need to ensure you’ve got some of your £20,000 ISA allowance left. You will then need to use your investment platform’s Bed and ISA service. With this, the investment outside the ISA will be sold and the proceeds transferred into an ISA. They will then be used to immediately buy the same investment within the ISA.
Note that Bed and ISA deadlines tend to fall several days before the end of the tax year, so starting sooner rather than later is recommended.
Read more here.
Cash or stocks and shares ISA?
Although you may be tempted by a cash ISA that offers a tax-free space for regular saving, you need to take care not to miss out on the benefits that come with a stocks-and-shares ISA. When it comes to medium and long-term financial goals – those with a timeline of five years or more – an investment ISA is likely to be the better choice.
As with a cash ISA, your interest in a stocks-and-shares ISA is protected from income tax, so you don’t have to hand over any of the return your money is generating to the taxman. You do need to be aware that this comes with some risk, as the value of your investments can go down as well as up. The key is to do your research, invest regularly, and diversify across different sectors, countries, and asset classes. You can also dip a toe into investing with small amounts, starting from as little as £10 or £20 a month. These small amounts will grow significantly over time, thanks to the compounding effect, with returns helping to generate even more returns. The beauty of ISAs is that they allow you to grow your wealth – and withdraw investments – when you want, without having to worry about a heavy tax bill at the end.
No need to declare income or gains on a tax return
As you may know from bitter experience, completing a self-assessment tax return can be time-consuming and stressful, especially if you need to include investment income or capital gains. The good news is that because any income or gains on investments held with an ISA are tax-free, there’s no need to declare them on a tax return. That’s one less thing for your to-do list.
What about dividends?
For dividends, the government halved the annual tax-free allowance from £2,000 to £1,000 at the start of the 2023–24 tax year and is set to halve it again from 6 April 2024, to just £500. Once your dividend income breaches the allowance, you’re liable for tax.
The amount you pay will depend on your income tax band. A basic-rate taxpayer will typically have a tax rate on dividends over the allowance of 8.75%, whereas a higher-rate taxpayer will have a dividend tax rate of 33.75%. For an additional rate taxpayer, the rate will be 39.35%. Because dividends earned from shares sheltered within an ISA are not taxable, there’s a lot to be gained from holding income-generating assets within an ISA. With thresholds and allowances frozen, you need to focus your efforts right now on protecting your investments from the taxman.
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