Investors looking to boost their incomes by wrapping shares paying dividends in ISAs, pensions and other investment vehicles may fall into a tax trap.
Although investment schemes are labelled ‘tax free’, many investors could improve their returns by not sheltering equities.
That’s because the way the tax system works in Britain means dividends paid on shares are taxed at source, so if they are held in an ISA, tax is still due on the payment regardless of the wrapper.
An ISA or pension still provides a shield against capital gains tax on any increase in value on shares, but not on the income they pay as dividends.
For basic rate taxpayers – paying income tax at 20% or less – offers no incentive for saving tax on income generated by holding shares in an ISA.
Bed and breakfasting
For higher or top rate taxpayers, ISAs are still an attractive option because they would pay extra tax on their dividends if the shares were owned outside an ISA.
This tax loophole does not make ISAs a no-go zone for basic rate taxpayers who want to own shares because the CGT benefits may still come into play.
However, many basic rate taxpayers may have other options for dealing with capital gains tax depending on whether their disposals in a year breach the annual exempt amount.
Although some time and planning is involved, investors can ‘bed and breakfast’ their assets each year.
Bed and breakfasting involves selling some stocks and shares each year and rebuying the same or similar assets.
The disposal washes any gains away and resets the CGT base value to zero.
SEIS advantages
Another advantage of holding income-earning equities outside an ISA is any capital gains tax losses can be offset against other gains, such as disposal of buy to let property.
Similarly, holding shares in a start-up company in a Seed Enterprise Investment Scheme (SEIS) that fails generates CGT losses that can be offset against other income, while assets sold to invest in a SEIS come with a 50% CGT exemption.
Meanwhile holding stocks and shares outside an ISA allows an investor to shelter savings and other investments in the tax wrapper that grow in value rather than produce an income.
A couple with a combined annual ISA allowance of £30,000 who both pay income tax at the basic rate could extend their tax-free holdings with some careful planning without paying any additional tax on their dividend income.
After all, under tax rules, they will still have this deducted as source anyway.
