The main step you need to take to legally minimise the level of tax that you pay is to do your homework - hey, this is about DIY investing! Tax regulations vary by country (and by State in the UK) - and 'vehicles' (or accounts) for shielding your income and wealth from tax also vary.
So some of the information below is general - in the sense that it could apply everywhere - and some is specific to particular localities.
General Approach
As general comments, you should consider:
- main taxes to consider: income/savings tax, capital gains tax, inheritance/estate tax
- transferring assets to another person (for example, your wife or children)
- consider using a tax-sheltered account or investing approach
- is it better to pay tax now or later (for example in retirement, when - for example - your income tax rate may be lower)
UK
The main (UK) taxes that are involved in saving/investment are:
- Income Tax; everyone has an annual tax-free allowance
- Capital Gains Tax (CGT); everyone has an annual tax-free allowance
- Dividend Tax
- Savings Tax
- Stamp Duty/Stamp Duty Reserve Tax (on buying shares)
You can't do much about Dividend Tax and Stamp Duty but you can minimise Income Tax, Savings Tax and CGT.
This strategy is DIY, so have a look yourself a the government's own help-site.- Transfer assets to your spouse
To keep it simple I would suggest that you can narrow it down to two measures to minimise the impact of these taxes:
- if you are married, put your cash savings (and possibly income-generating investments that are not in an ISA) in the name of the spouse who pays the lower rate of income tax (if your spouse is not working - even better, you will pay no tax up to her personal allowance)- Build up your investments in a Stocks & Shares ISA
A Stocks & Shares ISA (Individual Share Account) is shielded from Income Tax and CGT - investments can grow inside without exposure to these taxes - and you can withdraw your investment whenever you choose (although you would be silly to, unless it was really necessary - as once taken out, it cannot be put back).
An ISA investment is paid for in post-tax income but is tax-free if/when you withdraw your money.
Opening a Stocks & Shares ISA is easy (How to save or invest in an ISA). The DIY Income Investor strategy is based on doing everything on the Internet - so make sure you get an online share dealing broker. There is a lot of information on ISAs easily available - for example, here.
You should also open one for your spouse (so that you can use their allowance as well - and possibly even your children (although there are restrictions on how much you can give them).
If you already own shares - for example old paper shares - consider transferring them into an online Stocks & Shares ISA as soon as possible. Before doing this investigate any potential exposure to capital loss (hey, the market is rising) or Capital Gains Tax - for example, if the shares are worth more than you paid for them, consider only transferring shares up to the value of your annual CGT each year.
- Save in an Internet SIPP
A SIPP (Self-Invested Personal Pension) is a retirement fund from which you can only withdraw when you reach a statutory age (55 at present). The main difference with ISAs is that any tax can be reclaimed (at your highest rate of Income Tax) when you invest in a SIPP but income taken from a SIPP (as a pension) is taxable.
Internet SIPPs are available that have very similar features to Internet Stocks & Shares ISAs. There are some differences in what types of asset you can put into the two different accounts, but this is not significant for the DIY Income Investor approach. The main issues are when you pay tax and when you can get access to the income from your investment.
US
The tax situation in the US is more complex and arguably less investor-friendly than the UK. Quite honestly, I am less familiar with it - so I would appreciate any feedback.
However, there are still ways of avoiding tax.
- Municipal ('Muni') Bonds
Both municipal bonds and municipal bond funds (also called tax-free income funds) can help you earn income that's exempt from federal tax and, in many cases, state and local income taxes as well, as described here.
A municipal bond is an IOU issued by state and local governments and their agencies to raise money to fund public projects such as schools, hospitals and bridges. The entity that issues a bond makes interest payments to bondholders to compensate them for the use of their money until the bond is repaid. These interest payments are generally exempt from federal income tax. In addition, for residents of the state in which the bond was issued, interest payments are also typically exempt from state tax.
Interest payments you receive from a municipal bond are exempt from federal tax, so there is no additional benefit if your savings are in an IRA or 401k, which are not taxed anyway. Municipal bonds generally pay lower interest rates because of their tax benefits, so there is little reason to hold them if you are not receiving that benefit.
In addition, f
or investors subject to the alternative minimum tax, fund dividends may be taxable and distributions of capital gains are generally taxable. Finally, dividends are generally subject to state and local taxes, if any.
Municipal bonds are sensitive to interest rate movements, and a fund's yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a fund adjust to a rise in interest rates, a fund's share price may decline.In addition, f
or investors subject to the alternative minimum tax, fund dividends may be taxable and distributions of capital gains are generally taxable. Finally, dividends are generally subject to state and local taxes, if any.
More info on Muni bonds here.
- US Savings Bonds
US Savings Bond exclusions represent another opportunity to save from the taxes you are otherwise required to pay on your investments. All or part of the accumulated interest can be deducted if the following requirements are met:
- If in the year of redemption you have to pay for the expenses you incur for qualified higher education.
- If you are single and filing your statements individually
- If your income doesn't exceed a legally-defined level
Another opportunity by which you can increase your money without incurring any tax burden is through the investment in a Roth IRA. Under the conditions of a traditional IRA, you don't have to pay taxes on the accumulated amounts. However, once you start to withdraw money from your account you are liable to taxation. On the other hand, with a Roth IRA, your withdrawals are free from taxes (as it is paid on the income going in) - with certain restrictions.
- 401(k) / Roth 401(k)
A 401(k) is a type of account run by employers to help their employees save for retirement. Employees can choose to deposit part of their earnings into a 401(k) account and not pay income tax on it until the money is later withdrawn in retirement. Interest earned on money in a 401(k) account is not taxed before funds are withdrawn.
Employers may choose to, and often do, match contributions that workers make. The 401(k) account is typically administered by the employer, while in the usual "participant-directed" plan, the employee may select from different kinds of investment options. Employees choose where their savings will be invested, usually, between a selection of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.
Since 2006, another type of 401(k) plan is available - participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separately-designated Roth account, commonly known as a Roth 401(k). These "Roth" contributions will be collected and treated as after-tax dollars; that is, income tax is paid or withheld in the year contributed. Qualified distributions from a designated Roth 401(k) account, including all income, are tax-free. (A traditional 401(k) account is funded with pre-tax dollars and, in general, tax must be paid when the original contribution and earnings are withdrawn.)
For more information, have a look at Oblivious Investor's Where to buy an IRA and Roth IRA withdrawal rules and 'Roll over your 401(k) into an IRA'.
For more on legally avoiding US tax see CashMoneyLife's 7 Simple Tips to Legally Pay Less Tax
I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.
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