I’ve deliberately kept politics out of this blog as much as possible. It rarely seems to bring out the best in people — myself included.
However, there are some radical plans regarding the taxation of investments in the manifestos for the upcoming general election that are worth highlighting.
How things have changed
Let’s review how we got to the current state of play first, though.
I’ve been an active investor for about 25 years now, so I’ve seen a lot of changes to the way savings and investments are taxed. Older readers will have seen considerably more, including much higher tax rates in the 1970s.
When I started, PEPs and TESSAs were all the rage. They soon gave way to ISAs, although the basic principles were fairly similar.
Pensions were clunky and expensive and final-salary schemes were already rare outside the public sector. Although SIPPs were introduced in 1990, it took a while for them to hit the mainstream.
Pensions were, er, “simplified” in the 2006 A-Day reforms which brought in such things as the Lifetime Allowance and paved the way for endless tinkering with the amount you can put into a pension.
More recently, we’ve had new tax-free allowances introduced for savings and dividend income. However, the biggest change for most of us has probably been the 2015 pension reforms that gave people much more access to their money.
Tax rates have been falling
For the most part, the changes in the taxation regime have been favourable to investors over the last 25 years.
Back in 1995, there was an annual capital gains tax allowance of £6,000. This has doubled to £12,000, so it’s largely kept pace with inflation.
The capital gains tax rate has dropped considerably, though. It was charged at the same rate as income tax up until 2008, but the current regime is 10% for basic-rate taxpayers and 20% for higher-rate taxpayers.
Of course, there have been a few wrinkles along the way, with different rates introduced for property gains, for example.
The amount we are able to put into ISAs has increased from £7,000 to £20,000 over the last 20 years. The changes in this limit have mostly come in three big leaps (just before general elections but I’m sure that’s just a coincidence!) rather than smoothly increasing each year at the rate of inflation:
- £7,000 to £10,200 in 2009;
- £11,880 to £15,000 in 2014; and
- £15,240 to £20,000 in 2017.
Overall, ISAs have become a lot more attractive since they were first introduced, with the range of investments you can put in them widening as well.
If the ISA subscription limit had kept pace with inflation, it would be around £12,500 today.
Dallying with dividends
The taxation of dividends has become more complex recently. As an investment trust investor hoping to live off their dividends one day, this is something that I have a keen interest in!
Most of my portfolio is in ISAs and a SIPP, but I do have some investments left out in the harsh sun of taxable accounts.
Up until 2016, dividends were untaxed if you were a basic-rate taxpayer, but you paid 25% on the amount received if you were a higher-rate taxpayer. For simplicity here, I’m going to ignore the old system of dividend tax credits.
The thinking behind this is that the profits that dividends were paid from had already been used to pay corporation tax. So, a lower rate of income tax was charged on dividends to eliminate any double taxation.
However, it was felt this was being abused by some business owners. The government shook up the rules:
This measure will help address the incentive for some people to set up a company and make payments as dividends rather than as wages simply to reduce their tax bill, enabling the government’s plan to reduce the rate of Corporation Tax.
The measure will modernise, reform and simplify dividend taxation, creating a fairer system. Only those with significant dividend income, or those who are able to pay themselves dividends in place of wages, will pay more tax. Around 1 million individuals will pay less tax on their dividend income due to the new Dividend Allowance.
A £5,000 dividend allowance was introduced which was promptly sliced down to £2,000 the following year. New dividend tax rates of 7.5% and 32.5% were introduced for basic- and higher-rate taxpayers.
What is being proposed now
The Lib Dems are looking to get rid of the annual Capital Gains Tax allowance — income and capital gains would be taxed through a single allowance (it’s not clear if this will be set at a different level to the current Personal Allowance of £12,500). I presume the same tax rate would be applied to both income and capital gains.
The Lib Dems are also proposing to increase corporation tax to 20%. It’s currently 19% and the Conservatives were proposing to reduce it to 17% next year but this idea has now been postponed. The Lib Dems are also proposing to add 1% to everyone’s income tax rate.
Labour’s plans are much more radical:
- the annual capital gains allowance will be reduced from £12,000 to a de minimis level of £1,000;
- capital gains will be taxed at income tax rates;
- a ‘rate-of-return’ allowance set at contemporary 10-year bond rates will allow capital gains below this rate to be earned tax-free;
- dividends will also be taxed at income tax rates;
- the dividend allowance will be scrapped — a de minimis level is proposed but no specific figure is mentioned (I guess this means it is £1,000 as well);
- corporation tax will be increased in stages to 26% by 2022/23; and
- income tax rates would be raised for those earning more than £80,000.
As far as I can see, no changes are being proposed to the ISA or pension regimes by either Labour or the Lib Dems — at this stage anyway.
There’s a good FT article that covers this and a whole host of other proposed tax changes in more detail.
The effect of the dividend tax
Let’s assume a company makes £100 of profit and it pays out all its profits after dividends.
With corporation tax of 19% and 7.5% for basic-rate dividend tax, this reduces to £75 in the hands of shareholders. They’re effectively paying 25%.
Labour’s proposals of 26% and 20% would leave shareholders with just over £59, increasing the effective tax to 41% for a basic-rate taxpayer. Those on their new Super-rich rate with incomes of over £125,000 would see an effective tax rate of 73%.
The scrapping of the dividend allowance would take a little bit more if you scale this example up to a full portfolio.
The effect on capital gains
This is trickier to calculate as capital gains vary considerably from year to year. But if you had a gain of £12,000 you would currently pay nothing. Under Labour, a basic-rate taxpayer would pay £2,200. Under the Lib Dems, it would be £2,400.
Any gains should be reduced by the rate-of-return allowance under Labour. However, it’s worth noting that the current 10-year gilt yield is just 0.65% which is well below the rate of inflation you used to get with indexation allowance.
I might be misinterpreting Labour’s intentions here as it seems strange to use a forward-looking measure like a gilt yield to calculate the tax due on a historical gain.
Like most investors, I’ve built up some capital gains over the years and I’m generally trimming these holdings and reinvesting the money. Most years, I’m using at least some of my capital gains tax allowance.
I’d probably have to rethink this strategy. I work part-time and am a basic-rate taxpayer. So I suspect I’d let my gains build up and wait for a more favourable tax regime in the future.
It does seem to me, though, that the people most affected by these proposed changes to dividends and capital gains, in percentage terms anyway, are likely to lower and middle earners.
Those with public sector pensions can largely rest easy, but if you have to build your own pension pot, things could get a lot tougher.
What might happen to investment trusts?
A lot of the investment trusts that were launched in the last decade are very much focused on income.
If dividends are taxed more heavily, these might become less popular. We could see the premiums on a lot of these trusts reduce.
Some companies might decide to pay out less. Investment trusts currently have to pay out at least 85% of their profits by way of dividends so they have some flexibility here.
Among my individual holdings, HICL Infrastructure and Gresham House Energy Storage Fund are probably the most likely to be directly hit by a Labour government’s nationalisation plans. I’ve kept my position sizes on the small side here because of this.
What’s the likely result?
You’re asking me?
At the time of typing, the Conservatives had a lead of around 10 percentage points. However, I’m surprised that the average sample size for most polls is just 1,500 people. There’s got to be a large margin of error here, but I’m not sure how much.
I can’t see many parties getting into bed with Boris (sorry for that image) should he fail to secure an overall majority.
A Labour-led coalition might not be able to introduce all the measures outlined in its manifesto but companies and investors are usually seen as easy targets.
The odds for a Conservative majority seem to be around 4/9, with 2/1 for no overall majority, 20/1 for a Labour majority, and 250/1 for a Lib Dem majority.
But I seem to recall you could get 5,000/1 on Leicester winning the Premier League a few years back.
A plan of inaction
As usual, my strategy is to do as little as possible when it comes to my portfolio. Chopping and changing because of macro or political concerns rarely makes sense.
Writing articles like this helps me focus on what might actually change and distracts me from doing anything rash.
It’s unclear how quickly any of these plans would be brought in if there was a change of government. I guess you could make the case for realising some capital gains now before the election, especially if you planned to do them anyway before the end of this tax year.
It’s unusual for changes like this to be backdated or made to current tax years, but it’s not without precedent.
Under Labour’s higher dividend tax rates, I might shift my non-ISA portfolio more towards trusts looking for capital growth rather than income. Of course, the lower limit for the capital gains tax allowance may restrict my options here.
I’m certainly thankful that most of my portfolio is in ISAs and SIPPs. It may seem like an additional faff when you’re starting to invest, but it’s at times like these that you’re glad you made the effort.
Of course, the tax protection these accounts offer could be eroded at some point as well. Some 18m people have cash ISAs and 7m have share ISAs (about 4m have both) but we could see some upper limits being imposed or subscription amounts being lowered.
In the case of pensions, the days of higher-rate tax relief have look numbered for some time now. And we could even see changes made to the 25% tax-free lump sum.
The other takeaway is that when you planning things like building a retirement income from a portfolio, you need to build in a buffer for unexpected hits. This could come from poor investment choices, lower than expected market returns, or potential tax changes like these.
As usual, let me know your thoughts in the comment section below. A little bit of politics is fine but I might delete anything that gets a little too spicy!
Please note that I may own some of the investments mentioned above -- you can see my current holdings on my portfolio page. Nothing on this website should be regarded as a buy or sell recommendation as I'm just a random person writing a blog in his spare time and I am not authorised to give financial advice. Always do your own research and seek financial advice if necessary!
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