In my own journey towards financial independence I utilise the benefits and advantages of a Stocks & Shares ISA to ensure that my investments and any dividends that come from those investments will be tax free.
But out of curiosity I recently asked myself:
"How much of a difference would it make if my investments weren't in an ISA?"
I've previously written about the power of passive investing and how the S&P 500 can always be bought at a low price so it's reasonable for me to expect my investments, provided I stay the course, to grow into something quite considerable in the future.
So the tax advantages of a Stocks & Shares ISA is something that I'll be using for sure, but what if I didn't and simply invested my money through a General Investment Account (GIA) instead?
Would I suddenly be exposed to tens of thousands of pounds in tax every year?
Provided that I stay within normal boundaries that apply for the vast majority of people out there (I'll explain what I mean by this later) I reckon the answer is that I probably wouldn't be. This is due to the variety of allowances available to everyone living and working in the UK that would give my income from investments some level of shelter away from the taxman.
To see if my suspicions were correct I went about doing some calculations.
Let's imagine a scenario where there are two people, John and Jane, who are diligently building their wealth over the long term by investing a regular amount each month. John invests via a General Investment Account (GIA) whereas Jane invests via a Stocks & Shares ISA.
They both invest £300 each month into an index fund that returns 7% on average each year and after 40 years they will each have a portfolio that is valued at £792,036.44. At this point they both decide to retire and will live off their investment income through a mix of dividends and by withdrawing (selling) a portion of their holdings each year.
To know how much money they are both receiving each year let's apply some general rates for the example; the index fund they have invested in has a dividend yield of 2% (similar to the S&P 500 average) and they will be withdrawing 4% of their investment portfolio's value each year in addition to receiving the dividend payment. Effectively they'll be taking 6% each year from their investments and that results in an annual income of £47,522.25.
Investment balance: £792,037.44
2% dividend: £15,840.75
(£792,037.44 × 0.02)
4% withdrawal: £31,681.50
(£792,037.44 × 0.04)
Annual income: £47,522.25
(£15,840.75 + £31,681.50)
Let's imagine that this is today's money so the tax bands, thresholds and allowances are applicable for the 2020/21 tax year. If you're not familiar with what the allowances are see below:
There are other allowances available but the above 3 are the ones applicable to the example. So you can immediately see that there's actually a fairly generous amount that an individual could earn in a year without needing to pay any tax.
Added together there would be an allowance of £26,800 which is equivalent to a salary of around £34,000 before tax.
Let's see how this affects the difference between Jane's and John's incomes.
Stocks & Shares ISA vs General Investment Account
Since everything earned or gained within a Stocks & Shares ISA is tax free there is nothing needed to be done by Jane, she doesn't even need to notify HMRC about her income. She can simply enjoy the £47,522.25 for the year without needing to do any tax calculations or reports.
Nice and easy.
John on the other hand will need to work out his gains and dividend amounts and see how he can utilise the different allowances in order to keep his tax bill at a minimum.
The first thing he needs to calculate is the capital gains on his investments as tax is only owed on the value that was gained after he bought in (his contribution). The easiest way to work this out is to take the average cost per unit and then compare that to the price that each unit was sold for; the difference is the gain (assuming the difference is positive) and that is the part that may have a tax liability.
Now you might have already realised that we don't actually know how many units John has bought over the 40 years, and since we don't know the cost per unit we'll need to make do with a different method.
All we know is that John invested £300 each month for 40 years which eventually grew to a value of £792,037.44. Luckily we can work with this information to determine which portion of his investments is his "contribution" and which portion is "gain".
The ratio between contribution and gain will then determine how much of the withdrawal from John's investments is actual profit and therefore subject to the capital gains tax calculation. Here's the maths:
Total contribution: £144,000
(£300 x 12 months x 40 years)
Investment value after 40 years: £792,037.44
(Average 7% growth each year)
(£792.047.44 - £144,000)
Contribution ratio: 18.18%
(£144,000 ÷ £792,037.44)
Growth ratio: 81.82%
Based on the above ratios, 81.82% of the amount that John withdraws (no matter how much he withdraws) from his investments is profit and will need to be calculated as capital gains. With this ratio decided we can begin to break this down to understand how much of John's money is liable for tax:
Note: The basic rate tax band is used as the total taxable amount after personal allowance is less than £37,500.
There's quite a few moving parts but essentially after taking into account all of the available allowances for the tax year, John only pays a total of £1,462.74 in tax on the £47,522.25 income that he received. Effectively that means John only paid about 3% in tax overall.
Amount received pre-tax: £47,522.25
Tax paid: £1,462.74
Effective tax rate: 3.08%
(£1,462.74 ÷ £47,522.25)
Amount received post-tax: £46,059.51
(£47,522.25 - £1,462.74)
For reference, if you had a salary of £47,522.25 from a standard job where you would have to pay income tax and national insurance you'd be paying around £11,500 in taxes. Quite a bit more than John's £1,462.74.
So it looks like my initial suspicions weren't far off, there's definitely some tax to pay but considering the amount of income being taken each year it's not really that much.
How applicable are the example numbers?
Naturally if you have an exceptionally large investment portfolio then the impacts of tax will be greater and the benefits of a Stocks & Shares ISA will become much more obvious. A fair question to ask at this point would be:
"How applicable are these numbers and assumptions?"
Well, let's take a look at some official data and see how they fit within the example. From the Office for National Statistics there are two key data points that I think are important:
Average weekly household spending in the UK was £585.60 in (FYE) 2019
Median household net wealth is around £286,600 based on data from April 2016 to March 2018
Average household spend is £30,451.20 (£585.60 x 52 weeks)
The median household net wealth is around 2.76 times lower than the investment wealth amount used in the earlier example (£792,037.44 ÷ £286,600)
So effectively the average household spend is lower per year than the amount of money being withdrawn in the earlier example (£30,451.20 < £47,522.25), and the median wealth is much lower than the wealth enjoyed by Jane and John (£286,600 < £792,037.44).
With these observations we can broadly say that less money spent means less money needed from the investment account, which in turn leads to less money being taxed since the withdrawal and dividend amounts are less likely to be above the allowance limits. There's also less money available since the median net wealth is lower and that would similarly lead to a lower withdrawal amount assuming the withdrawal rate stays at around 4%.
An additional thing to note is that the median household net wealth recorded by the ONS likely includes ownership in property and not just money saved or invested. So that £286,600 isn't all in a General Investment Account which again leads to the conclusion that the money generated from investments would be lower in reality.
This is what I meant at the start of the article when I said that I probably wouldn't be exposed to tens of thousands of pounds in tax "provided that I stay within normal boundaries that apply for the vast majority of people out there". The majority of people out there won't have that much in investments, which is actually quite unfortunate considering how easy it is to become a millionaire.
So back to the question, the example's numbers may be higher with an investment balance of £792,037.44 but the resulting tax owed is low; so it's reasonable to say that the tax owed when using more "standard numbers" based on ONS data will be similarly low.
In fact, there might not be any tax liability if the money comes from the right place and utilises the correct allowance (dividend or capital gains). If that were the case it would almost be like the money was within a Stocks & Shares ISA after all.
So I don't need to use a Stocks & Shares ISA?
Well let's not be too rash here, it's true that John didn't need to pay too much tax on his income but that doesn't mean you should just casually discard your ISA allowance.
Let's all remind ourselves of a few of the benefits of a Stocks & Shares ISA:
Returns and gains are not liable to income tax or capital gains tax
Dividends are not taxed
An ISA allowance can be inherited by a spouse or civil partner
No need to do any tax calculations or report to HMRC
Financial calculations and personal accounting can be confusing and tricky at times, especially when it comes to working out which part of your investments is considered capital gains. We made some general assumptions in the example which I think gives us a good sense on what's involved but usually it's best to find a professional accountant to make sure you're not misreporting.
If your investments were within a Stocks & Shares ISA you wouldn't need to care about any of that since it's all sheltered. To be honest, this benefit alone would probably make it worth going with the Stocks & Shares ISA instead of a General Investment Account if you had the option to do so.
There's also the situation where you might be getting income from other sources such as a pension, royalties or even employment (who's to say you've actually retired!). These income sources might also utilise your allowances which could then expose more of your investment income to taxation, even if the amount of investment income is low.
That's not all, there are certain scenarios in which your Stocks & Shares ISA would outshine a General Investment Account even if your numbers were "average" as described earlier and you had no other income sources.
Imagine if something happened and you needed to make a bigger than expected withdrawal from your investments, let's say something in the region of £100,000 or more. I have no idea what this situation might be, maybe it is a pretty big financial emergency or maybe a promising investment opportunity related to real estate appeared and you needed a lump sum to get involved.
Whatever the reason might be, if you needed to make a larger than expected withdrawal all at once then the tax liability would also increase since you cannot bring forward your future allowances to cover it. This would hurt even if the tax rates were low because under normal circumstances you'd be able to spread things out over time and stay within the allowance limits, paying even less tax overall.
This would not be a problem if your money was within a Stocks & Shares ISA since you can withdraw however much you want tax free; even better is if the ISA was flexible and you somehow managed to make some or all of the money back within the same tax year.
Ok... so if a Stocks & Shares ISA is so advantageous what's the point of me writing this article about how much it really matters?
Well my intention was never to discourage you from using a Stocks & Shares ISA in the first place; I just wanted to dive into the workings a bit more to really understand how much of an impact it makes. I also genuinely believe there are some people out there who could benefit from understanding this a little better (I'll give examples below); we're all trying to improve our financial literacy at the end of the day.
The ISA allowance hasn't always been as generous as it is today so there might be people out there who have built up a pretty nice investment pot that isn't tax sheltered with the extra money that didn't fit into the ISA for previous tax years; they might be wondering how they're going to be impacted by this.
There might be people who just weren't aware of the Stocks & Shares ISA and have tax exposed investments. Since you can't directly transfer holdings into an ISA (you need to sell first and then buy it back) they might be wondering what the tax cost to them will be if they leave their investments in a General Investment Account any longer.
Someone might have been the recipient of a rather large windfall and cannot put the money fast enough into a Stocks & Shares ISA since they keep maxing the annual limit. They might wonder if it's worth investing the excess or wait for it to be tax sheltered first.
Or some people might just be curious on how much of a difference it really makes.
All in all, there could be a number of reasons to why people might benefit from this information and to be honest, I just thought it was quite interesting to explore.
Ultimately, I don't know of any reasons not to put money into a Stocks & Shares ISA as opposed to a General Investment Account if the option was available. It certainly feels much more straightforward when it comes to any calculations or reporting and if there aren't any drawbacks then "why not"?
But at the same time there are also a number of other tax favourable benefits and allowances that are available to everyone which can make their investments (almost) equally as tax efficient. So here's the question once more:
"Does a Stocks & Shares ISA really matter when it comes to tax?"
Based on some very loose assumptions and boundary setting, and with some official data to back things up my answer would be:
"Yes, but maybe not as much as you expected."