When you buy shares in a company, your ultimate aim is to generate a return, a profit from that purchase, you can do this in a number of ways. After buying shares in the stock market, you generate returns either through selling the shares at a higher price than you bought it, thus generating a capital gain, or you can receive cash bonuses in the form of dividends. This is similar for other financial products such as Investment funds where you can also generate a capital gain or receive a dividend. The other type of return one can generate is through interest from assets such as bonds and other savings products. But you know how it goes, whenever we make money, the tax man is always sitting there, rubbing his hands and licking his lips, ready to take a big chunk of those profits for himself. In this article I cover how capital gains and dividends are taxed, why it is important to know this and how we can shelter ourselves from Mr Tax man in the most effective ways.
When you buy shares for the first time
Many people don’t know about this type of tax until they click on that ‘Deal’ button and see the fee included in their purchase. Paying ‘stamp duty reserve tax’ on shares has the same kind of the similar concept to paying VAT on items we pick up at the store. It’s not too big, sitting in at 0.5% of the value of the trade. This tax is automatically incurred when investing in a UK company (or if foreign, but still registered in the UK)
You don’t have to pay this tax on considering the below:
1. You don’t pay this on ETF’s, or OEICs
2. Don’t pay this on foreign shares
3. New shares issues
4. Shares that are gifted to you
Personal tax bands & tax on our profits:
OK, so we just spoken about the tax you may need to pay as you buy shares, but what about once you start making money from those shares. Even before we get to this, there is something we should all know about ourselves and that is our personal tax bands. The question is, what type of tax payer are you? This is important because it also translates into how much tax you may end up paying as you generate earnings from stocks & shares investments.
We all have what we call a personal allowance of £12,500 this tax year (2020-2021), meaning we can generate this amount of money through various ways and not have to pay tax on it. Remember that any profits you make from investments will be added onto any other types of income you receive in order to calculate your full income for the year, this includes your typical wages. If your overall returns exceed the £12,500, then below will show you what type of tax payer you are.
Basic rate - £12,501 - £50,000 (20% income tax)
Higher rate - £50,001 - £150,000 (40% income tax)
Additional rate - £150,001 + (45% income tax)
Based on this guidance, you should be able to tell me what type of tax payer you are. This is important for the next section.
In addition to the personal allowance, we also have what we call a dividend allowance every year. This year, the allowance is £2,000, meaning you can receive up to this amount in dividends and not have to pay dividend tax. In fact, you don’t even have to tell HMRC anything about your dividends if its below this threshold, and of course if it is held in a tax efficient account like an ISA. But your investments are held in a general investment account, then as soon as you go above this, the tax man needs his share. How much you give him will depends on what type of tax payer you are. So first add the dividends income to all the other types of income you receive and that will tell you the tax band that you belong to. If you’re a basic-rate tax payer then you pay 7.5%, higher rate then 32.3% and additional rate 38.1%.Remember this is the tax you pay on what is Above the £2k allowance
Capital Gains Tax
Ok so you bought some shares, they have gone up in value and now you want to bank those profits by selling the shares at its new higher price. Brilliant! You will not have to pay any tax on any ‘profits’ totalling up to £12,300. Key word here is profit, meaning you only ever pay tax on profit. If your profits exceed the £12,300 allowance, then similar to the dividend tax, you pay a different amount of tax depending on what tax band you belong to. In this circumstance
Firstly you don’t pay this tax if the shares are bought in a tax efficient account like a pension or an ISA. You also don’t pay this tax on government bonds and other qualifying bonds. You also may not need to pay this on employee shareholder shares.
If you go above the threshold then you have to pay 10% for basic rate tax payers and 20% for those higher.
To avoid paying dividend tax or capital gains tax from owning shares, make sure to buy them in a tax efficient wrapper like a stocks & shares ISA or SIPP. All ISA’s are exempt from the dividend and capital gains tax, and you have an allowance of £20,000 this tax year. You can also look to use up the pension account, where you can invest an amount equal to your salary up to £40k per tax year. This is probably the most tax efficient way of investing as you also benefit from no income tax. However, make sure you understand all the pros and cons of these accounts before using them.
Lastly, if you have already taken advantage of some of these accounts and still have cash to invest, then general investment accounts are fine, just keep in mind the above information. This can help you make a decision as when to sell stocks fr a profit in a given tax year, and how many dividend paying stocks you want to own.