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Effective methods

The importance of the effective rate of tax when considering how to maximise returns

The well publicised view of Warren Buffett that the super-rich are not paying quite enough tax reminded me of the importance to overall wealth management of the “effective rate of tax” that an individual pays. Warren felt that his estimated overall rate of 17.4 per cent of total earnings was way too low compared with the rates paid by his colleagues, which were apparently around double that paid by him.

The reason, as I explained last week, was the different rates of tax applied to different “flows” – in Warren’s case, dividends and capital gains.

The importance of the effective rate of tax is one that investors would do well to remember when considering how to maximise returns.

As I have said on more than a few occasions, while portfolio appropriateness, performance and charges are of paramount importance in driving returns, tax – at both fund and investor level – also has a big role to play. When it comes to product wrapper choice, key variables, such as the relative levels of income and gains, current and expected future tax rates and available exemptions, will all be critically important to determining the overall “effective rate” of tax borne by the investor.

At fund level, the Isa and the registered pension scheme reduce the effective rate of tax on gains and income to an unbeatable nil. This is carried through to the investor for all Isa returns and the PCLS (taxfree cash) from the pension. Of course, any income drawn from the pension is fully subject to income tax but possibly at a level lower than that at which any personal contributions were relieved.

These two portfolio wrappers (the Isa and pension) are excellent examples of “effective rate reducers”. Such is their effectiveness (regardless of gains or income) that tax freedom for 40 per cent taxpayers can increase returns by 66.6 per cent and for 50 per cent taxpayers by 100 per cent – eat your heart out, Mr Buffett – possibly at an “all you can eat” buffet. Sorry , couldn’t resist it.

But even beyond registered pensions and Isas, understanding and careful wrapper selection can seriously improve the investor’s bottom line (and, no, your bum does not look big in that) by reducing the effective rate of tax payable on income and/or capital gains.

Broken record time… adviser dogma over wrapper choice can seriously damage the investor’s (net) wealth. Suitability (of product wrapper) for each investor depends on key variables.

Broadly speaking, capital gains will be most favourably accumulated inside a collective and for higher and additional-rate taxpayers, income within an insurance bond – on tax grounds. I am leaving charges out of it and assuming that the portfolio that passes the suitability test for an investor can be secured in any wrapper. Where it cannot, then it is likely that availability is likely to be a key determinant.

So, assuming we are all good with choice and charges, we can then set about reducing the effective rate of tax to minimise outflow and maximise return.Obviously, the most effective rate of tax is nil and that is exactly what you get on capital gains made by a fund manager of an authorised collective when managing your investment within it.

Being able to manage investments with no concern for tax should be quite liberating, with, hopefully, beneficial results. And if the investor can realise gains within their annual CGT exemption, the effective rate will be nil. Of course, if tax-free capital gains at fund level are allowed to roll up over a considerable period, then there is a good chance (on a reasonable investment) that the realised gain will exceed the investor’s available annual exemption.

That is why it is so important in “effective tax rate” management to seek to uplift the base value of the portfolio each year, if practically possible, through rebalancing and legitimate “bed and” strategies. The impact of this over a number of years can be significant. With a nil “fund tax” rate and maximisation of the use of the CGT annual exemption every year and on final realisation, the effective tax rate can be kept super-low and this will have a very positive effect on net returns.

Another way of using the annual CGT exemption to deliver a “sweet n low” effective tax rate on regular amounts withdrawn is to take amounts from a collective investment so the gain element falls within the annual CGT exemption. A nice and relatively easy way to deliver “tax free” income. Well, not actual tax-free income but effective tax-free sums.

This strategy can, of course, by used by each of a couple as each person has an annual CGT exemption – and remember the annual CGT exemption is on a use it or lose it basis.

Another way of minimising tax on capital gains is to let market volatility remove all or part of previously accrued gains – but let’s not go there.


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