Ten Steps To Financial Freedom Step 8: Keep The Taxman At Bay
- Step 1: The Miracle Of Compound Returns
- Step 2: Get Control Of Your Money
- Step 3: Beat Banks At Their Own Game
- Step 4: Dump Your Debts
- Step 5: Make It Home Sweet Home
- Step 6: Retire When You Want To
- Step 7: Invest! Seriously, It’s Simple
- Step 8: Keep The Taxman At Bay
- Step 9: Make Your Child A Millionaire
- Step 10: Protect Your Wealth
Pretty much all the income you earn is subject to some degree of taxation, but the good news is that the government likes to encourage people to invest so that they aren’t dependent on the state in their old age. This means there are a range of tax-efficient ways you can keep at least some of your money protected from the taxman’s clutches.
At first, when you start saving or investing, any savings you might make may seem quite small. But tax liabilities can build up over time, so a little forward planning can end up saving you a lot of money in the long run.
However, be wary of choosing an investment scheme predominantly because it might save you tax, which is often referred to as “letting the tax tail wag the investment dog”. As a general rule, such schemes don’t tend to perform very well, so we suggest finding an investment that you think looks promising first, and then look at what the most tax-efficient way of holding it is after that.
The Individual Savings Account (ISA)
The simplest way to protect your money from income tax and CGT is to hold your savings and investments in an Individual Savings Account, or ISA. An ISA is essentially a tax-proof wrapper for your money: as long as it’s tucked inside an ISA, you shouldn’t have to pay tax on any income, or gains you make from your money.
ISAs can seem a little complicated and the government tends to tweak the rules for them on a regular basis. They’re well worth investigating, though. Many people who have invested in them regularly have built up substantial portfolios that are totally protected from the taxman. You can find out more about them in this Fool guide.
If you have an index tracker (see Step 7), you should definitely consider putting it in an ISA. It’s a tax-savvy move that shouldn’t cost you anything extra, and it could significantly boost your returns in the long run.
We talked about pensions in Step 6. If your employer offers an occupational pension scheme, it will usually make sense to join it. If you don’t have the option of a company scheme, you can start a personal pension, a stakeholder pension, or even a self-invested personal pension (SIPP).
All pensions offer relief from income tax, but they work slightly differently than ISAs: if you’re a basic-rate taxpayer and you put £200 a month into a pension, the Government will give you tax relief on this amount, boosting your investment to £250 a month. Higher-rate taxpayers are able to claim more tax back – in this example they would be able to claim a further £50 a month back from the taxman via their tax return.
Money within your pension is free to grow without being taxed. However, once you begin to draw your pension, the money you draw from it – your income – is then taxed at that point, although you will be able to withdraw up to 25% of your pension as a tax-free lump sum, if you want to.
Inheritance tax: the taxman’s last hurrah
Inheritance tax is the last tax you will ever have to pay. Here’s how it works: your estate is valued at the time of your death, and a certain amount is tax exempt. The balance is then taxed at 40%. Your estate is the aggregate of all property owned as well as any significant transfers of wealth made within seven years of death.
A number of exemptions arise with inheritance tax, including transfers between spouses, gifts to charities, annual gifts, gifts in consideration of marriage, and a lifetime gift. One way to avoid inheritance tax is through the use of trusts, although can be quite complex so you should seek advice from a solicitor or financial advisor.
A final note on tax and your money
With a little time and effort, ISAs, pensions, and even trusts can save you from paying a fortune in tax. Just remember, the more money you put in and the longer you keep it there, the greater your potential tax savings will be.