You have only a modest pension income. You rely on income generated from a share portfolio to top this up but are increasingly worrying about falling prices and low dividends. What might you look to use to diversify your investments?
Turbulent times
The coronavirus crisis has impacted share prices, meaning that the value of some portfolios will have dropped significantly. A further effect is that many large firms have suspended or significantly lowered their dividend payments. For wealthy individuals, this may be no more than a blip. But for those who rely on dividend income to partly fund their lifestyle, the effect may be felt more keenly. Of course, with the increase in the number of firms entering administration, some people could well be worrying about the longer-term impact.
Although it may seem counterintuitive, given rock bottom interest rates that look to be in place for the foreseeable future, from a tax perspective, you may be able to benefit from changing some of your existing stocks and shares investment portfolios to interest-bearing investments.
Pro advice. The income yield may be lower, but these kinds of investment are much safer than equity investments and may be a good option for parking value in order to weather the coronavirus effect where you are worried about falling share prices.
Who might benefit?
Those that still have access to their starting rate for savings are likely to benefit most from a change to interest-bearing investments, examples of which include interest received from unit trusts and open-ended investment companies, corporate bonds, or even a run-of-the-mill bank account.
The headline starting rate for savings is £5,000 in 2020/21, with interest falling into the band taxed at 0%. However, the band reduces by £1 for every £1 of other income above a taxpayer’s personal allowance, meaning most taxpayers with other income, i.e. non-savings, non-dividend income, of £17,500 or more in 2020/21 are not eligible for the starting rate for savings.
Pro advice. The amount of dividends you receive has no bearing on the availability of the starting rate for savings, as savings income is taxed in priority to dividend income.
Pro advice. The starting rate for savings is different to the personal savings allowance (PSA), which is currently £1,000 for basic rate taxpayers, £500 for higher rate taxpayers, and £0 for additional rate taxpayers.
Taken together, this means that the starting rate for savings and the personal savings allowance can be used alongside the dividend allowance (currently £2,000) to maximise the tax benefits. Let’s look at some case studies to illustrate how this might be done.
Case study – lower earners
Jan receives the state pension and a modest personal pension, which amounts to £10,000 per year in total. She also receives £8,000 in dividends from a share portfolio held outside an ISA. After accounting for the personal allowance and dividend allowance, her tax position for 2020/21 would be a liability of £262.50.
However, if she had £8,000 of interest instead of dividends, the combination of the personal allowance, starting rate for savings and PSA mean there is no tax liability.
Pro advice. In most circumstances, it is not as simple as swapping from dividends to interest and receiving a broadly similar level of income. However, if you hold shares in companies that aren’t currently paying dividends it might well be realistic, at least in the short to medium term. There is also the potential benefit of capital preservation that doesn’t affect income tax but is important.
Case study – middle earners
Although interest-bearing investments offer tax efficiencies, it is not always beneficial for you to hold large amounts of such investments from a tax perspective. Returning to the Jan case study, let’s suppose the facts are the same, but now the amount received is £12,000.
If this is all received as dividends, the tax liability is £562.50. However, if it is all received as interest, this increases to £700. In this example, Jan is worse off with solely interest-bearing investments , as her savings income is taxed at the basic rate of 20%, while her dividend income is subject to the lower dividend rate of 7.5%. As a result, it is often more beneficial to hold a mixture of interest-bearing and non-interest-bearing investments, to maximise the utilisation of all the allowances available.
A mixed portfolio
Returning to Jan again, let’s now assume that she speaks to her IFA and decides to diversify her investments. She still receives the £10,000 in pension income, but now receives £8,500 in interest and £3,500 in dividends. The personal allowance, starting rate for savings, and PSA, and dividend allowance are all now utilised to leave just £1,500 of the dividends subject to tax at 7.5%. The tax liability would be £112.50, which is a clear saving.
Higher earners
The personal savings allowance in 2020/21 reduces to £500 for higher rate taxpayers, while additional rate taxpayers have no PSA. Despite the more limited opportunities for these clients to maximise tax-free allowances on interest-bearing investments , there are still effective planning options available.
You may be more receptive to hearing about ways you can maximise the tax efficiency of your investments more generally at the moment, whether from an income tax or capital gains tax perspective, following the Office of Tax Simplification’s review into capital gains tax in November 2020.
One option is to make use of a spouse or civil partner, by giving them the proceeds of a share sale so that they can acquire investments of an interest-bearing nature. If the spouse is a basic rate taxpayer, or earns below the personal allowance, then some interest-bearing investments may provide greater tax advantages, as in the Jan examples.
Pro advice. If you are contemplating disposing of shares in a private company, ensure that any requirements as laid out in that company’s articles of association are met.
Higher earning clients that do not have a spouse or civil partner still have avenues they may explore; selling shares and acquiring interest-bearing investments through an ISA or SIPP as an example.
Don’t forget ISAs and pensions
Finally, a brief but important word about pensions and ISAs. Clients may need to be reminded of the tax benefits that both can bring. While an ISA is typically seen as more flexible, as a client’s money isn’t locked away as it is in a pension, making personal pension contributions certainly has its benefits, not least that it can offer higher earning taxpayers the opportunity to extend their basic rate band.
Clients with a high proportion of equity-based investments should consider diversifying their portfolios to benefit from the savings-based tax allowances. This can produce savings but is also a useful way of protecting capital value in difficult economic times. Don’t forget to review the capital gains tax position.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.