Readers! I hear your cries!
“Art, enough of this interesting content!”
“Art, we come here to be bored by finance speak, not mildly amused!”
As any good writer must, I bow to your feedback. So here’s a blog on optimising your taxes. You’re welcome.
Straight off the bat, there are a couple of things to take into account when looking at tax optimisation. The first is that its something you should think about and potentially benefit from at pretty much any level of income. The second is that the vast majority of tax optimisation advice relating to FIRE is based on the US tax code and has zero applicability to the UK. The third, and most important, is that I’m talking about tax optimisation and not tax avoidance/evasion.
I want to highlight the third one as for many people taxes are an unalloyed evil. I’ve even met some people who say the don’t “agree” with taxes (I don’t like these people). In my mind, there is nothing more hypocritical than refusing to pay tax while enjoying the fruits of what taxes fund: from the police and fire departments we rely on, to safe roads, a fantastic and free medical system and a state safety net. We should all pay taxes. That’s the end of it.
Having said that, I don’t think we need to pay more than our fair share. In the UK, there’s only really a couple of effective ways to reduce your tax at normal income levels. Options open up when you’re earning serious money but if you’re in that category, you should probably be speaking to a professional rather than listening to my generalist thoughts on the subject!
Let’s keep this short and sweet – below I will discuss the two biggest and best ways to optimise your taxes. Note, as always, this is not advice specific to your situation but general educative content. Please do your own research and consider seeing a professional advisor for tailored advice.
ISAs – a savers best friend
So how do ISAs work? Put simply, they protect any savings in them from tax. Any form of tax. They do include a limitation though: you can only add up to £20K each tax year into any of your ISAs. Thankfully, for many of us, this is more than enough!
There’s two types of ISA: cash ISAs (savings accounts) and stocks and shares ISAs (accounts where you can buy stocks and shares).
If you put your savings in a cash ISA, no tax on any interest earned. Sweet, but at current pathetic rates of interest on savings accounts, not really worth our time.
Here’s where it gets really interesting: there are also no capital gains or interest taxes on any income or capital gains from a stocks and shares ISA. This is a game changer.
So let’s talk about what you’re avoiding by investing via a stocks and share ISA rather than a taxable account. Standard capital gains taxes on investments (excluding residential property) is 10% up to your personal allowance. After that its 20%. If you’re a top rate tax payer its 20% from the start.
If you invest via a stocks and shares ISA you can seriously boost your return (e.g., easy maths, earn a 5% return rather than a 4% return). Over longer time periods this can seriously add up: £20K invested over 20 years will become just over £53K at 5% compared to just under £44K at 4%.
The last big benefit? Money taken out from your ISA is tax free as well making it the perfect tax vehicle for FIRE.
Pensions – the biggest and best way to save on income tax
We all remember the moment we received our first pay cheque. The anticipation, the tearing of the perforated paper. Slowly unfolding it to see what our hard work has earned. Then the crushing disappointment at the end figure!
Its a hard pill to swallow, even after years of work. What’s more, the better you do the worse it gets. Let’s quickly review the tax bands (where your wage is in the second column and the tax rate in the third):
| Personal Allowance | Up to £12,570 | 0% |
|---|---|---|
| Basic rate | £12,571 to £50,270 | 20% |
| Higher rate | £50,271 to £150,000 | 40% |
| Additional rate | over £150,000 | 45% |
45% top tax rate. Ouch. Thankfully only a minority will ever get to this level. However, that’s far from true for the next band down: if we work hard, get lucky or play the game well, a gross wage over £50K is certainly achievable. For those that do, 40% of their wage over this hurdle will go to the government and that’s not even including national insurance or student loans!
So what can we do about it?
There are a few things but really only one that can work for everyone: you can save into a pension.
The massive pro: when you save into your pension, it comes out of gross income and not net income. Lets break this down. Imagine you get paid £55K a year. After tax this comes to ~£40.6K of take home income (effective tax rate of 26.2%). Let’s say you save half of this in your ISA. You’re now the proud holder of £20K of savings and £20.6K of regular income to spend on rent/food/pets etc.
Now let’s look at what happens if you save half in your pension. Here we look at gross pay, so £55K. You save £27.5K in your pension, leaving £27.5K. After tax, £27.5K is £22.4K (effective tax rate of 18.3%). Overall you now have £27.5K of savings in your pension and £22.4K of regular income. You’ve gained an additional £10K off the same pay cheque!
That’s the magic of pension saving. However, here comes the caveat. You can’t access it until the state pension age. Which is currently 55 but is expected to increase. Not so helpful if you want to FIRE early…
There is one hidden benefit here though, it forces you to leave the money where it is to compound, which we know is the number one way to get rich.
So there you have it. Tax optimisation in two easy steps. As with so many things, the best path is probably a bit of both:
- Saving into your pension so you get a couple of decades of compound interest working for you in the background;
- Taking enough as taxed income to save into your ISA (which provides easy access) and gives you enough to have a pleasant life in the meantime!
Thanks for keeping with me through this! Next up, a nice palate cleansing Zen post. Until then.