Paul Kennedy: The central role of tax in investment planning


While investment performance is generally depicted in terms of gross return, tax habitually dictates what part of that return ends up in the investor’s pocket. Clearly, the investor’s spending possibilities are constrained to the return after tax and one might argue it is this that counts.

Investing in a great performing fund in a tax-inefficient manner may, in fact, ultimately equate to investing in a much poorer performing fund in a tax-efficient manner. Despite this, many facets of investment planning remain almost completely blind to tax.

Modern portfolio theory ordinarily assumes an investor does not consider tax when making decisions and is indifferent to the type of investment return. In real life, the type of return, whether dividend, interest, capital growth or some other form of payment such as pension income, are all fundamental.

Each is often taxed in a differing way and at a different rate. Furthermore, certain types of investment return have annual tax-free allowances, again at differing amounts, and others do not.

If interest will be taxed at 40 per cent, whereas dividends or capital growth at 0 per cent, it surely follows that the underlying risk analysis may be somewhat flawed if tax is ignored. In essence, an investor taking a risk of “X” to invest in equities compared to fixed interest might be seen to be taking somewhat less risk if the dividends and capital growth are tax-free whereas 40 per cent of the fixed interest return is lost in tax.

This equation can be put in many other ways. The fundamental point is that once tax is imported the risk versus reward equation can look different. Arguably, models developed in a pre-tax framework do not necessarily equate to the post-tax framework and asset allocation should encompass tax considerations if it is to be accurate.

The interaction of tax within portfolio diversification and asset allocation theory is a complex subject. There is a number of academic papers on the subject, albeit emanating from foreign jurisdictions not directly considering the hugely (by comparison) complex UK tax system. Maybe there is a thesis in it for me one day. Of course, all of this is largely confined to academia unless and until the investment modelling tools used every day by advisers can incorporate the complexity.

But that is not to say we should ignore things altogether. With a bit of clever thinking, appropriate placing of relevant assets in relevant tax wrappers, and a degree of intuition we can influence the investor’s net return. Indeed, we have known for many years that certain tax wrappers are more or less advantageous for different types of investment return. However, the new tax year will see us having to step up our knowledge and strategies another notch.

From April 2016 we shall see the introduction of a dividend tax allowance and a savings tax allowance. These will operate alongside the normal personal allowance, the annual capital gains tax allowance, and the existing savings tax 0 per cent band for those within the income threshold. Fundamentally, there will exist some form of tax-free allowance for most forms of investment return, whether dividends, interest or capital growth. The sum total of these tax free allowances can amount to a not insubstantial £33,100.

Running alongside, there is the annual Isa allowance and pension allowance, which are two wrappers that operate very differently. The Isa is free from liability to personal tax, while the pension provides some tax-free cash and simply taxes any income payment, both being blind to the amount or type of investment return as such.

To use the tax-free allowances, appropriate assets must be in appropriate wrappers. To use the dividend allowance or the capital gains tax allowance one must use tax wrappers that fire into those regimes. That equity assets might be sitting elsewhere in a tax-free wrapper is not necessarily an optimum position as investors might be better using that tax-free wrapper for different returns that would otherwise be taxed.

Investors who plan to ensure they suffer less tax on their investment return will enjoy their wealth more. Developing an asset allocation model that optimally places assets into appropriate wrappers is not an academic nicety; it is about real pounds and pence. And it is a strategy where professional advisers can add untold benefit for their clients.

Paul Kennedy is head of tax and trust planning at FundsNetwork