The taxman is coming for your dividends – ISAs are the main defence

Young ‘uns know this already, but there are a lot of older folk who swear by share certificates and shouldn’t. My Dad was one – wouldn’t touch this newfangled nominee account rubbish when it was introduced[ref]he was a canny old boy in many ways – when he retired in the mid 1980s and the company retirement FA suggested he used unit trusts for diversification the FA got sent off with a flea in his ear because the fees on the suggested unit trusts in those days were absolutely huge. But he didn’t get PEPs or ISAs later on[/ref]. The trouble with certificates[ref]There are some advantages – your cost of carry is zero, and you are less likely to turn over your portfolio because of the aggravation[/ref] is you eschew any kind of tax wrapper, which seem to be nominee only. There’s a bit more pressure on these refuseniks now because the taxman is coming for your dividends in a big way. Once upon a time, if you had dividend income that wasn’t greater that the higher-rate tax threshold[ref] if you had no other income[/ref] you could get it all tax-free. Well, last year they pulled that down to £5k a year. And from roughly this time next year it’s coming down to £2000, all due to the Budget.They are clearly after unwrapped dividend income, largely to stamp out the practice of self-employed directors paying themselves a token wage and then a massive amount in dividends. It’s worth noting that the tax on dividend income is still much lower than the tax on actually selling your time for money to an employer, 7.5% (update – I misrepresented the total here – PJ’s comment sets the record right on the need to account for corporation tax too in the case of the self-employed, though not the dividend-income shareholders) as opposed to 20%, but it’s a book-keeping nightmare for people who hold individual share certificates or people who hold unwrapped equity holdings on many platforms[ref]if you hold loads of shares on one or two platforms each platform gives you a consolidated tax certificate for the dividends across your entire portfolio which makes the job of reporting the dividend total a lot easier[/ref].

Most dividend yields aren’t usually much more than 5%, so this means that you are sort of okay with up to ~£40,000 worth of shares, but why take the risk? Get your shares into an ISA[ref]If ISAs aren’t enough to contain your vast wealth then I guess you are probably rich enough to use offshore tax havens and find suitable advice ;)[/ref] – and you have until 5th April to take action this year to bed-and-ISA some of these suckers. But be warned of capital gains tax, so don’t crystallise gains of more than £11k a year. If you need more than that you can do other stuff, like use your SIPP and you can also give shares to your spouse, but whatever you do do it, and do it now and early next year.

I had a CGT gain that it’s taken me the last few years to run out into an ISA. Next tax year is my last crack at that sort of game, after which all my equity holdings will be in ISAs or SIPPs. I will still retain the empty unwrapped account if it doesn’t cost me anything. After all, you never know, we may be due for another market crash, and if I start thinking along these lines, and can raise the cash, and have the cojones, I may be grateful for more than £20k equity purchasing capacity that year. Then I will take the time to chunter that into the ISA over the following years.

From a capital gains point of view, even if you want to maximise your ISA savings, you may be better off crystallising the existing gain in unwrapped holdings of Company X and investing 20k of the same shares in Company X in your ISA, even if it means you buy 20k worth of some different shares of Company Y unwrapped[ref]Or you leave it a month before you rebuy Company X[/ref], because that resets the CGT clock on the unwrapped holdings. Some platforms give you a better deal on costs if you bed and ISA – TD, who I used, is one of them. But if you have share certificates then don’t putz about with that for this tax year – you usually have to get your share certificates into a nominee unwrapped account and then do the Bed and ISA from that. It’s very likely you just haven’t got enough time for the Crest forms to go through in time for this tax year end.

You have three tax year end periods before you get hit with this – 2016/17, 2017/18 (after which the cut to 2k will happen, due in 2019) and 2018/19, so get with it.

Listen to what’s written between the lines

The chancellor is quite right, in that the self-employed white van folk have been playing merry hell[ref] they get less too, they don’t accrue entitlement to contributions based Jobseeker’s Allowance[/ref] with the tax and NI system compared to PAYE employees. Last year I paid a whopping £150 to buy a year’s worth of State Pension accrual – that’s something that used to cost me thousands of pounds a year as a PAYE grunt. It’s easy to attack that sort of loophole, which is why the next tax year is the last year I will get such a good deal. I am chuffed that it is my 35th year out of 35 needed and I shall pay my £150 Class 2 NI contributions with alacrity for one last time for tax year 2016/17.

distribution of the rise in class 4 NICs across the income spectrum (Resolution Foundation)

But the self-employed also take the piss in another way, and that is the ‘company director’ who pays himself a pittance wage with the majority in dividends. These were the guys who were targeted by last year’s dividend tax allowance of £5000, but the tax paid is only 7.5% relative to he PAYE grunt’s 32%. As a higher rate tax payer you’re up to 32.5%, which is still a better deal when I was paying 41% (nowadays 42%) tax on PAYE when I was younger and hadn’t discovered what pension savings are there for.

But there’s another bunch of NI mickey-takers out there, and yes, there’s a mustelid of white pelt in there too. These are the people living on a pension. There is no NI to pay on a pension, and somehow what with all the talk of fairness and the fact that Britain’s true tax rate is about 32% for basic rate taxpayers rather than the headline 20% I can see that changing in not very many years hence. First they came for the self-employed…

There’s probably a lot more tax win to be had among the self-employed. Not the ‘self-employed’ Deliveroo drivers on zero hours contracts, it’s the “company directors” paying themselves and their wives in dividends. You gotta follow the money, and that 7.5% dividend tax level starts to sound far too low for future years, too. The Deliveroo guys don’t pay themselves in dividends, it’s the well-heeled self-employed that are in the Chancellor’s gunsights here.

Saving equities in the uncrystallised part of my SIPP is a small way to fight back?

One of the ideas I thought if I wanted to hold non ISA shareholdings is – what if I hold them in the uncrystallised part of my SIPP? Say I hold £1000 of Megacorp paying 10%. So I put 1000 into my SIPP and the taxman makes this up to £1250. Megacorp pays me 10%, ie £125. I drift this £125 off to my crystallised pot. Because I will always be a BRT taxpayer soon because of other income, I get to pay 20% tax, ie  £25, ending up with £100. Bugger. But on the other hand, without going through this I’d have only got 10% of £1000, which is, drum roll… £100.

Now if I’d held that in my unwrapped trading account, and accumulated enough to pay tax on it then I get to lose 7.5%, ie end up with £92 from Megacorp p.a. I don’t have a huge need for my SIPP once my main pension starts paying out. I will save my £2880 p.a. to get my 25% boost from the taxman up to £3600. On 75% which I get to pay 20% tax, boo, hiss, but it’s still worth it, because £720-£540=£180, which is a 6.25% guaranteed ROI for two months of a year, and where the hell else are you going to get that on cash these days?

But if for some reason I had money coming out of my ears and a 20k ISA limit was not enough, I could get a £2880 increase on that by misusing my SIPP. People who are working can do better than that, provided they become basic rate taxpayers in drawdown. Beats holding it all unwrapped and no need to sweat capital gains. If Megacorp goes up 100% I get to pay tax on the price if I sell, but hell, I bought 25% more of it at the lower price because of the taxman’s bung. The uncrystallised portion of my SIPP looks like an interesting place to hold equities after my ISA compared to an unwrapped trading account. On the downside, the potential 32% tax and NI merger could gut the value of doing that.



How a short pension can help early retirement around 55, and why annuities deserve a better press

One of the dilemmas facing the early retiree is how to minimize taxes. The extreme early retiree (<45) doesn’t have much choice but to pay tax on their savings to retire between their extreme early retirement date and the time they can draw pension income. You can avoid paying tax on the way in to a pension, but ISA savings are from tax-paid income. Now that Osborne has made pensions more attractive by improving their flexibility,  people need to start thinking how they are going to phase taking their retirement funds. That’s something you need to think about in you early to mid forties; at least ten years before the planned date of retirement.

I got a few of these things wrong, because I brought my retirement plans 8 years forward over a period of three years. In particular, consider very carefully whether you want to pay off your mortgage before retiring. Although I did, a mortgage is a flexible and low-cost loan. For most people not paying it off until you receive your pension commencement lump sum at 55 is the correct route, because it lets you smooth your income profile. Pay the mortgage down while you are working and before 55 and you will be better off in the long run but will probably take a severe income suckout in the gap between retiring and 55

There has to be the usual wealth warning – pensions are still complex, and people’s circumstances goals and risk profiles will vary a lot. DYOR and/or seek independent financial advice.  This is a tour of some of the high-level stuff. the devil is in the detail with pensions, but high-level stuff makes orientation easier.

Planning for slightly early retirement (55 and up)

In principle, planning is relatively easy for someone retiring after the Government’s mandated earliest DC pension drawing age, currently 55 but probably rising for anyone who is currently younger than 42. You basically save into a personal pension aiming at your annual desired retirement income * 20 by the time you are 55. I said the planning is relatively easy, doing it isn’t! Then you start drawing down the pension. If you want to leave it to your children after death then you carry on in drawdown, but if you don’t you can get some security against outliving your savings by keeping an eye on annuity rates as you age, and switching to one when the annuity return in terms of annual income gets above your investment return (~5% usually). This is usually around 65-70.

Planning for early retirement (45-55)

The planning gets harder for someone retiring before the Government’s mandated earliest retirement date. You have to save up from taxed income, preferably in an ISA. That’s been made a bit easier with the increased limits. Anybody who is in a position to retire early is different from the general working population, usually in earning more than average and probably also in spending less than average. Somewhere you need to open up a spending-earning gap. Unless you can get your spending down dramatically you’ll probably be paying higher rate tax on the money as you earn it to save across the gap

The same applies to me – all the money I’ve saved into my ISA and all the cash savings I have are from taxed income, and I was under the impression that once you’ve paid tax, that’s it. You don’t get to claw it back years later.

After the Budget changes, that’s no longer so. An early retiree’s tax status changes from

status tax NI age income from
working x x < retirement work
retired, pre-pension <55 savings
retired drawing pension x 55+ pension

One of the advantages of a DC pension is you can choose how much to draw down each year. You take 25% of the total pension capital as a tax-free pension commencement lump sum. Many people blow this on a holiday or other splurge, each to their own.

That'll be a nice Lamborghini, and to hell with the money
recommended splurge target these days

Some use it to discharge their mortgage on retirement, which has a hell of a lot to be said for it. But one of the other things you can use it for is to reduce the amount you draw down from the pension at the beginning, to less than the personal allowance of about £10,000

Such an individual’s stages look like this

status tax NI age income from
working x x < retirement work
retired, pre-pension <55 savings
retired drawing pension + PCLS 55-60 10k pension DD + PCLS “DD”
retired drawing pension x 60+ pension

That way you get a few tax-free years out of your pension. Note that I have made the assumption of at least a £250,000 pension capital, because drawing > 10k p.a. from any smaller amount would be unwise[ref]The PCLS takes it down to about 200k, and 1/20th of 200k is 10,000[/ref]. If you are drawing less than the personal allowance then you aren’t paying any tax on your pension unless you have earned income, in which case why are you drawing down your pension – ask your financial adviser about taking the PCLS from a DC pension at 55 and elect to draw down nil for a bit 🙂

It’s one low-risk way of improving your income from the pension, though investing the PCLS using an ISA and giving yourself a permanent tax-free increase in income is a good alternative. This is the one I have to take, because when I crystallise my pension I get both the income and the PCLS at the same time.

A change in tack for a pre-pension retired Ermine

That retired, pre-pension phase before 55 (or whenever you take your main pension income) is where you are living from savings or ISA income. It is precious, because you are a non-taxpayer. And there’s an opportunity opened now for you to claim some of the tax you paid on your savings back, indirectly 🙂

Non-taxpayers can save up to £2880 into a pension each year, to which the Government adds basic rate tax of 20%, ie £720 on £2880. You paid the tax when you saved the money in the first place. It’s a straight 25% gain[ref]the missing fifth that the taxman stole from you when you earned the money is returned, which is 1/4 of what you pay into the pension, hence a 25% bump-up[/ref]. If you do this for four years you will end up with a capital amount of 14400, for an investment of 11520. It’s a five for the price of four offer, though your first year’s contribution will have depreciated in value by about 12% due to four years of inflation[ref]my illustration is a bit pessimistic on that because it doesn’t discount end effects. For instance if I put in £2880 at the very end of the 2013/14 tax year, ie now, then presumably that cash has been earning interest for most of the year, so there are only two years and a month for inflation to erode it to mid-April 2016 when the operation ends. Likewise my last contribution goes in after April 2016, as soon as it’s gained the 2016 tax bung I close the SIPP and take the cash out[/ref]

You won’t get a 25% real return because charges are high on SIPPs – these plus the effect of inflation halve the return. I’ve computed this for a TD Direct SIPP. This isn’t the cheapest place you would go – a stakeholder pension from Cavendish is better value but TD already know me and I am hoping they will open the account before the weekend, so I can put in £2880 for the year 2012/13. The extra £720 HMRC will add (less the £345 it will have depreciated due to inflation by 2016) still makes it worth paying over the odds for. If they can’t get their act together then I’ll use the cooling-off period to back out and go to Cavendish with a stakeholder later on next year.

Charges and costs with a TD SIPP for 4 years

inflation 3% 3% 3% 3%
tax year starting in 2013 2014 2015 2016
pay in 2880 2880 2880 2880 11520
tax added 720 720 720 720
TD open charge 0
drawdown cost
flex dd reg 75
close 75 90
annual (£40/0.5%) 40 71 142 211 704
running total 3560 7089 10547 13936 13846
profit 680 649 578 509
running profit 680 1329 1907 2416 1462
inflation depreciation 86 86 86 86 346
86 86 86 259
86 86 173
86 86
total lost to charges 704
total lost to inflation 864
roi 13%

All the charges and the effect of inflation reduce the return to 13%, but it is a return without exposure to the vagaries of the stock market – just open your SIPP and either leave a lump of cash in it or use a money market fund that is sort of like cash. [ref]That is a stupendously crazy way of using a normal SIPP over decades, but for something that’s only going to be there for three years I don’t need to take stockmarket risk, though I will if a market swoon presents itself in that period[/ref] I would be able to take £3461 as the 25% tax-free lump sum and withdraw the remain £10384 as income without paying tax as the tax threshold should hopefully be at £10500 by the 2016/7 tax year.

There was a load of bellyaching from DB pension holders that they got nothing from Osborne’s changes. If you are a DB pension holder so crazed as to even think about transferring out to DC then stop right now and take a cold shower. To be honest, if you have a DB pension you should STFU and celebrate your good fortune in life and salute any tail wind that can help people out to make a DC pension work better for them. If you want to get the benefit of Osborne’s changes then you know what to do – damn well get out there and buy a DC stakeholder and stop whingeing.

Which is exactly what I am trying to do. I tip my hat to commenter Boardgamer who clearly located the on-switch of his brain a bit quicker than I did after hearing Osborne’s changes 🙂

Annuities, schmanuities…

Annuities have come in for an awful lot of stick recently, much of it unfair. From pensions A-day in 2006 nobody has had to take an annuity on retirement, only after they reach 75, and annuities are a hell of a lot better value at 75 because life firms figure you have one foot in the grave, and they know they’re paying out for fewer years than if you are 55. The screaming about annuities is only because people holler at their financial adviser that they want it SAFE AS HOUSES, not in the BIG BAD STOCK MARKET where their capital value marked to market MAY GO DOWN. CASH NEVER GOES DOWN – I WANT SAFETY.

Be careful what you ask for. Safety, and insurance, costs money. That’s why annuities are so shit at 55 or 60. So don’t be a nutcase. You entered the stock market over years with your pension savings. You will have lifestyled your pension savings to reduce equity exposure as you come up to retirement. But if you are retiring into a world where the stock market goes down and stays down on its knees from the long-term CAPE10 trend for 10 years then that is a world where you’ve probably got bigger problems than your pension. Starving hordes running through the streets, lack of clean water, that sort of thing. That’s not a country for old men…

All the scaredy-cats will say BUT THAT’S WHAT HAPPENED IN THE DOTCOM BUST

even this mahoosive shart doesn't manage to span an Ermine's shortened career
even this mahoosive FTSE100 chart doesn’t manage to span an Ermine’s shortened career. And it doesn’t show dividend income.

Well, yeah, but the dotcom boom was way above the CAPE10. People retiring in Feb 2003  had been putting money into the stock market for the previous 30 years[ref]probably using ghastly with profits funds and shocking fees, but that’s a different problem, and has been largely solved now by regulation[/ref].

Yes, they retired with an inflated idea of what their savings were worth, and the guys retiring three years before got a much better deal if they annuitised on retirement. But they didn’t lose out – they got damn good value from their savings, assuming they saved at a high enough rate, targeting the right capital amount. They’d have seen a big overshoot in 1999/2000. Maybe they should have taken the hint and retired then. Or if they had lifestyled their pension savings (transiting to an increased bond allocation and downplaying equities as they approach retirement) they wouldn’t have seen much of the boom, but then even less of the bust.

In short, do it right, guys. This information isn’t secret any more, and is standard financial advice 101. I lost a shitload of money in the dotcom bust, because I started in ’97. If you retired in 2003 you probably were in your peak earning years from 1993, and were buying tons of cheap shares from the 1973 oil crisis onwards[ref]Current savers should note there is a school of thought flagging up that expected stockmarket returns may be lower in coming years than historically. The FCA has mandated change to low, mediaum and high projected returns on pensions from 5,7 and 9% to 2,5 and 8%[/ref]. You didn’t lose out that much overall. And you did much better with 30 years of pound cost averaging than a wet-behind-the-ears ermine buying over three years at the peak of the market then running into index ISAs 🙂

Annuities aren’t inherently bad, just stop buying the suckers as soon as you retire. Consider  a mix of drawdown and annuitise when you’re older. Nobody’s had to buy an annuity on the date when they retire for a long time. People say annuity rates keep on dropping. Yes, annuity rates for a new annuity at 60, say, are dropping. If you know a way to be 60 this year and still be 60 next year you’ve got hold of a secret that is worth a hell of a lot to a lot of people, you don’t need a damn annuity. The annuity rate for YOU as an individual will improve as the years roll by ‘cos you ain’t getting any younger[ref]it is possible to invent scenarios where this doesn’t happen, but your personal annuity rate will increase at an accelerating rate as you get older, the cross-point may shift from 65 towards 70[/ref]. You can test this with any annuity calculator. Tell ’em your age and see the rate. Then tell ’em you’re 10 years older.

People often blame annuities for a very different problem. Not saving enough money. We are starting with a capital value of roughly 20 times the annual desired retirement income, yes? If not, you’re gonna have to stay at work until State Pension Age or start robbing banks until it is 20 times your desired income…

The trick of delaying annuity purchase only really works for people who retire normally, say at 60. If you retire with a pension capital of 20 times the desired annual income and your age related annuity rate improves enough to save your tail at 70, then you’ll have half of your capital left. You’ve been running it down for 10 years if your capital keeps up with inflation and you use a safe withdrawal rate of 5%. Do that for 20 years starting 50 and you are outta cash by the time an annuity can help you. Early retirees have to be more conservative with their withdrawal rate because they are exposed to risk for longer. They need to avoid running down their capital too fast.

Annuities are a tool, often used in the wrong place – at retirement. You are swapping stock market risk for inflation risk if you do that, because few people have saved up enough to eat the answer of “what is the rate if I tick the inflation-linked button”. The value of money halves about every 15 years due to inflation, so most people will get to see that.

The other place annuities get a bad rap is you can’t leave them to your kids when you die. Diddums. One of the few benefits of a DC pension compared to a DB pension is you could leave the unused capital to your kids  if you croaked before 75 and hadn’t taken an annuity. Now you can leave it to your kids even if you live to 105 or more. Your job now becomes saving up enough money that you can live like old money – off the income from capital, not running it down. You need to work for longer to save up more if you want to feather-bed your offspring, it’s as simple as that. Osborne has given you the possibility, Now do your bit – spend less than 1/30th of your pension capital in retirement and you have a better chance than the 4 or 5% commonly regarded as a safe withdrawal rate..

Your Risk Profile

FinaMetrica sums up the problem space well

Many financial decisions are made in situations of uncertainty, and so risk is involved. Different people are comfortable with different levels of risk.

Unlike, say, height or weight, there is no unit of measurement for risk tolerance. A person’s risk tolerance can only be measured relative to others on a constructed scale, in much the same way as IQ is measured.

By using the FinaMetrica Risk Profiling system, you obtain an accurate assessment of your risk tolerance in terms that are meaningful to you and your advisers. Your Risk Profile report will guide you and your advisers in your financial decision making. In particular, the report provides the basis for your instructions to your advisers on the level of risk you would prefer.

The reason annuities matter is that when people come to retire and take a DC pension, they are faced with a major life change. I have been through some parts of this, but many things are softened for me because I have a DB pension that I could live on if I took it now.

You retire in your 50s at the earliest, well, as far as retiring on a DC pension and getting to take it. For many people in their 50s, if you give up your salaried job you will find it very hard to find another one at the same level of pay. The reasons for this are complex, but generally

  • you have experienced notable career progression
  • 50 is an early time to retire, not many opportunities arise where firms would want to replace someone of that age with someone of a similar age
  • you are more settled housing-wise but still often have dependent children, so moving is more of a wrench, meaning you have to look locally, restricting opportunities
  • your experience fits a particular organisation, for instance although my general knowledge of engineering has a wide application elsewhere in industry a lot of my skillset is specific to The Firm, which is busy trying to get rid of its old gits. It’s definitely not hiring any more on the payroll 🙂

So retiring is a big move, it’s often a one-way ticket, and it’s stressful, even if you have enough money. People get fearful and conservative when in an unfamiliar stressful situation. And then your independent financial adviser walks along, glad-hands you, and sits you down with a cup of coffee. Then he says to you, right, Mr Retiree, how do you feel about risk? Say I were to tell you that the value of your stock market investments could fall 50% in one year, but it would probably not stay down. Well, he doesn’t actually do that, he opens his PC and gets you to do something like this online risk asessment or this Finametrica test

So there you are, you’ve just had the send-off from your workmates, you are going to enter a new phase of life, you have butterflies in your stomach, and now someone asks you how you feel about losing money, bearing in mind you aren’t going to be earning any more for the foreseeable future and probably the rest of your life. And what most people say is


What is this stock market you speak of that can chew through my money like that? Why would I give it house room?

So the IFA closes the laptop, looks you in the eye with an easy smile, and says Right Mr Newly Retired, that’ll be an annuity for you, Sir. Then goes through the spiel, looks on the open market and off you go with an annuity, and almost zero stock market risk. And I find that for an Ermine, for every £100,000 pension capital I can buy about £5000 as a level annuity payable annually from age 55.

No I don’t actually think that rate is too bad. It’s not a billion miles away from the 5% safe withdrawal rate from a stock market investment, and you’ll never outlive it. Trouble is, that every 15 years the value of this pension will halve. There again, 12 years after I am 55 the state pension will kick in, so the first bullet will be dodged[ref]How much that will help you depends on your pension income. If it’s £5000 then it’s a massive uptick. If your pension income is £100,000 then it’ll be lost in the noise[/ref], and that is inflation-linked to some extent. Now if I tell them I am grizzled of fur, 10 years older and I’d like it paid from 65 I get £6000 as a level annuity. Take a spin round the clock again at 75 and I’m good for £7500. Which was roughly the logic of why you had to buy an annuity at 75 at the latest; it’ll still be a damn good idea if you are a little bit short of money.

Talking about the risk assessment, in the interests of honest journalism I took a couple. And discovered I might have been rather too hard on the scaredy-cats, because it is possibe this looks very different to me. You can take the Finametrica test yourself at no charge. FWIW this is my result

An Ermine's risk profile
An Ermine’s risk profile I’m not having you on with April Fool – Finametrica is an Aussie company and they are 10 hours ahead of us

It’s lethal, more than one standard deviation away from the norm. I took the Scottish Widows one


Your Details

Name : An Ermine


Attitude to risk: Very Adventurous

Score : 84

The chart on the right shows where your attitude to risk fits:

About Very Adventurous Investors

Very Adventurous investors typically have very high levels of investment knowledge and a keen interest in investment matters. They have substantial amounts of investment experience and will typically have been active in managing their investment arrangements.

In general, Very Adventurous investors are looking for the highest possible return on their capital and are willing to take considerable amounts of risk to achieve this. They are usually willing to take risk with all of their available assets.

Very Adventurous investors often have firm views on investment and will make up their minds on investment matters quickly. They do not suffer from regret to any great extent and can accept occasional poor investment outcomes without much difficulty.

Yeah, right guys. Flattery will get you everywhere. FWIW I tried to be reasonably honest with the questions, though I did veer a little on the steady-as-she-goes when in doubt. It amazes me that I am such an outlier, more than one standard deviation off the mean. People normally get more conservative with risk as they get older, according to FinaMetrica.

The important thing here is that you should take one of these before your IFA does your pension, so that you have some chance to inform yourself about the options. Because otherwise our newbie testee, when faced with a whole load of questions where he doesn’t understand the question never mind the answer, will always go for the safe option. It may not reflect his views if he were better informed. This is a big decision, and if what you say points at the annuity way, you only get one shot. There’s absolutely nothing wrong in that, but it should reflect your view of the world, not your unawareness of the concepts. Oh and don’t pump up the answers just to make yourself look hard. It’s you who is going to have to live with the consequences. IFAs reckon that most amateur investors invest way above their risk tolerance. They would say that, wouldn’t they as they are talking their book. Nevertheless, when you look at the way private investors run for the exit just after a market crash they may have some point.

There’s probably also a good case to be made for you having run an ISA or a SIPP for about ten years before your retirement date, where you have some skin in the game – ie losing half the value would spoil your week, though not ruin you.

That way you get to see what a market crash looks like. You may think that you’re hard and can sanguinely whistle a dancing tune while there’s red all over your screen and where it said you had £200,000 yesterday it now says you have £100,000 and would Sir like to sell? If your feverished hands reach for the YES, DO IT NOW before I lose any more money button then you are not the Right Stuff. If it’s the ‘away with ye,  take me to the screen where I can add more money from my debit card and take advantage of this mayhem to buy low’ then you are probably the Right Stuff.

That’s the long story of why annuities have such a terrible name. They’re still right at times for the timid and may help those who are a little short of savings.


New Year’s Resolution 2011 – I want to pay less tax

Losing weight, getting fit – it’s all so passé IMO. What I want to change in 2011 is to reduce the amount of income that HMRC steal from me. I haven’t lived beyond my means over the last ten years and I’m damned if I want Hector the Taxman to swipe my cash to keep the bankers in champagne and dancing girls, or indeed the feckless to sit on their butts and breed us into Idiocracy.

Don’t get me wrong, I’m all for bankers, booze and birds as long as it’s not on my dime. I do think a pair of housebricks applied sharply to the offending organs might address Keith McDonald’s animal instincts but if he manned up and turned up for work to pay for them then 15 kids mightn’t be so bad. Either way, there’s enough that I seem to end up paying for, and I don’t want to pay for them any more, along these lines, though my bugbears are subtly different.

So how do you avoid tax, legally?

For wage-slaves like me on PAYE, there are only three easy ways to reduce one’s tax bill.

  1. Earn Less
  2. Spend Less
  3. Shelter taxable income in tax shelters like ISAs

1 and 2, the earns less/spend less do the heavy lifting here for wage slaves. If 3 is doing a lot for you you’re probably not on PAYE. What that means is to get a win here you have to be prepared to change your lifestyle. That’s why the taxman can raise enough money to waste on the aforementioned fripperies – because most people want to spend all they earn as they earn it.

Earn less, you might say, well, that’s like cutting off your nose to spite your face. However, there are ways you can reduce your taxable earnings while keeping hold of the money for deferred usage – things like pension AVCs (provided you can convert the saved money into a tax-free lump sum), some employee share plans and similar things like salary-sacrifice childcare schemes are ways to do that.

Of these, my weapon of choice is pension AVCs. Previously I have had a moderately successful run with employee share schemes, but you can only shelter £1500 a year that way and you take stock market risk. You can accept a lot of stock market risk in return for removing the risk of the taxman stealing 41% at source mind you.

AVCs are an easy win for me as I am probably within five years of drawing a pension. For younger people or those my age and not preparing to retire early the choice is harder, since a desperate government can change the rules at whim. At the moment one can draw 25% of a pension pot as a tax-free lump sum, and since I don’t want to draw this from the pension pot itself it makes perfect sense to save up 25% of my nominal pension pot on top in the form of AVCs, to withdraw tax-free rather than paying 40% tax on it. However I wouldn’t bet on that possibility remaining for ever…

I plan to use the £1000 extra tax allowance in 2011/12 that is one of the few useful outputs of the Lib Dem part of the Coalition. By controlling my taxable income I can avoid getting hit by the reduction in higher tax threshold and the increase in National Insurance to keep the money in my pocket, rather than Hector the Taxman’s. Incidentally, the same techique would enable Britain’s hard pressed ranks of impecunious middle-class parents to avoid the higher-rate tax child tax credit hoo-hah quite legitimately. Don’t want to lose your child tax credit? Don’t pay HRT. Simples. I think you have until 2013 to get ready for that change, so you can warm Tarquin and Jemima up to the fact they may have to share the iPad next  Christmas rather than get one each…

Reducing tax by reducing taxable income is easy enough to understand, though harder for some people to implement that others. However, the the gains to be had by spending less is due to a nasty hidden tax bomb that people often miss. Say you choose to live in Hastings and work in London, so your train season ticket costs £5192. For sure, Hastings is probably cheaper to live in, but you are losing £6800 of gross salary each and every year for the enjoyment of being packed in like sardines every working day, since you have to pay 20%tax, 12% NI on the money earned to pay that season ticket. The taxman also gets 20% of the ticket price as VAT (no he doesn’t, thanks to Ken below for setting me right on that) , so in total you are paying 50% tax for the privilege of going to work. Or if you are on higher rate tax then 60-70% of what you had to earn to pay the ticket goes to the government. I am assuming that if you earn over £100,000 and work in London you probably don’t live in Hastings 😉 If you did then you are being rushed even more.

Live below your means to get the flexibility to pay less tax

So the way to pay less tax is to spend less and do more for yourself. You have to have space in your budget to be able to do that, ie live below your means. If you spend out every penny you earn, you have no room for manoeuvre. The Government is smart this way and knows that most people in a consumer society end up living at, or above their means. As far as consumption taxes go, Governments pump up taxes on two classes of consumables – things people can’t easily eliminate from their lives, and wants that people can eliminate from their lives.

Fuel duty is one example of the former – over 60% of what you pay at the pump goes into the Government’s hands (and remember you’ve already paid about 30% tax on that money before it got into your wallet). Eliminating this sort of cost is difficult in the UK. For all the greenwash, public transport is a joke in the UK. I live 6.5 miles from work and the cost of the bus round trip is over £5 which is way more than twice the cost of the fuel. I actually have a choice here, and have driven down the annual cost of fuel considerably by cycling to work. That’s obviously not an option for our Hastings dwelling London commuter, and it highlights one of the issues about living below your means. You have to gain flexibility and control in your budget, and that means be very careful about picking up ongoing commitments.

Ruthlessly eliminate fixed costs from your lifestyle, consistent with your values.

These come with alls sorts of price tags and timescales. They’re bad because they suck flexibility out of your life, flexibility you could use to bust sociopathic managers and bad employers out of your way. On the upside, these fixed costs make a lot of good stuff happen for you life keeping the rain off your head, and reality TV to deaden the pain of your existence as a wage slave.

Commuting is a big fixed cost with a timescale matching how long you want to do the job/live where you do. An iPhone is a fixed cost, but at least it is a smaller cost that you can get out of after two years. Sky TV is a fixed cost to keep you from doing something else with your time, and a way to amplify your need for thneeds that you didn’t realise you thneed.

Taking financial responsibility for something that eats is a fixed cost that tends to be associated with a long timescale of about two decades, be it a kitten or a child 🙂 The costs, and rewards, are different for the kitten and the child, but they are fixed costs, and because the cost and the commitment duration are both high, it pays to be sure that’s what you want to do. Unfortunately for the country’s population of songbirds, and fortunately for the continuation of the human race both seem to find wide favour.

A mortgage is a high fixed cost, possibly one of the highest most people will take on, and it also has a long duration. It is crazy to take on a mortgage without a reasonable expectation that you will service it to the end (though accepted, not necessarily in the same house) since it hamstrings your flexibility and you lose so much on repossession.

Fixed costs are budget-killers because they are inflexible, though they are often associated with the greatest rewards. If you fall on hard times then you can switch from Waitrose organic salmon to ramen in a week, and you can forego the purchase of Manolo Blahniks and the spa session.

Reducing the mortgage, or the cost of your children’s clothes or kitty food are a whole different ballgame. Hence the personal finance stalwart of having an emergency fund of three to six month’s essential running costs in savings. Most of that emergency fund is there to address the fixed costs. My view is that three months is far too short. Take a look at this graph of the percentage of the unemployed who have been unemployed for more than 12 months

Percentage of unemployed who are long-term unemployed for over a year

The data is taken from the ONS. Now you have to ask yourself, with 12-month unemployment being the experience of a third of the unemployed, how good do you feel about a 3-month emergency fund? Now, granted, that 12-month statistic does include chavs like Keith McDonald so perhaps the odds aren’t so greatly stacked against people who actually want to work. However, if we assume the feckless are represented by the 20% figure in the boom times of the mid-2000s, the current 15% excess are probably real people, and look where that graph is heading.

It wasn’t meant to be like this – in the 1970s we were promised more leisure time. Capitalism delivered on part of the deal, though its dark, evil Calvinist heart hates increased leisure time for its workers, because that increases switching time and management costs. Materially, if you want the basics that so enthralled people in the 1950s, you can have that, but nowadays you only need to work half the time to pay for it.

You could argue we sort of have that now – Keith McDonald has worked out how. All he needs is a mug working full-time to sponsor his lifestyle of 100% leisure. I have realised that I can’t have the job I was promised, a 20-hour week paying me half my gross salary.

I am closer to that 1950s lifestyle than many as  I don’t have:

  • an iPhone
  • an iPad
  • an i-anything
  • a mobile (other than the work-provided one I use only for work)
  • a flat screen TV (I am toying with outing my TV this year anyway as I don’t watch it enough)
  • a wii/games console
  • Sky/cable TV subscription

By storing the excess half of my income, preferably keeping as much of it out of the hands of the Government as I can, I can quit working about fifteen years earlier than my Dad could. I was slow on the uptake – other people like Dreamer and ERE have managed a lot earlier in their lives than me.

My extra time working hasn’t been totally wasted – I have more stuff than Jacob including a house, and living in a motorhome is not totally my idea of good living, and the harsh exercise regimen is also not to my taste, I’d rather not prolong life by hating a lot of it… Each to their own, however, Jacob will live longer than me 😉

Sin taxes on elective wants

How about taxes that the Government puts on wants, that people can eliminate from their lives? The classic sin taxes on cigarettes and alcohol are examples of that, but there are others more nuanced, such as air passenger duty.

Although you wouldn’t think it from the way some people carry on, you don’t actually need to go on holiday, and even if you did, you don’t need to fly there. As for all that BS about air travel being good for people, well, it’s noisy for the rest of us on the ground, pollutes our air and buggers up our sleep. For the travellers, it is nasty, stressful and demeaning nowadays. If 80% of the travellers could be priced out of the sky I’d be all for it, I’d much rather save up and fly once a decade in comfort than once a year in a seething morass of humanity. Unfortunately, saving up to go business class wouldn’t help me, since it is the security theatre and airport experience which is the ugly part. I haven’t flown anywhere since a 2007 work trip which reminded me just how unpleasant air travel has become. Jean-Paul Sartre was spot-on, L’enfer, c’est les autres.

Warren Buffett has the right idea, if you want to do air travel, get a private jet. Since Warren is ever so slightly richer than me, I do without. By the way, if you really find the extra £100 APD an unbearable imposition then for heaven’s sake use your brains, APD is levied on flights from UK airports. Travel to Amsterdam-Schipol to start your long-haul flight, tax avoided, job done. Less racket in the skies for the rest of us above the UK too, what’s not to like?

Smoking. I don’t smoke, but if I smoked 40 a day it would cost me about £4380 a year according to the NHS. If I were a basic rate taxpayer I would have to find a job paying me £5840 a year more gross, to take into account the tax and NI I would pay before spending £4380. According to these guys, the cigarette duty on that hypothetical habit is £3942, so the total tax and duty in £5402.

Sin taxes are easy to avoid, don’t do the sin. I save myself nearly £4000 in tax by not smoking 40 a day. It’s kind of difficult to get a buzz out of the saving since I’ve never smoked 40 a day, but it’s there. There are also ways round some of that – if you have the capital to buy 7000 cigs every 6 months a regular trip to France may be in order, and indeed even pay for the holiday including APD…

Alcohol is the other biggie in sin taxes, and I get hit with £2 per bottle of wine roughly. So I know what to do if I want to reduce this 😉

A New Year’s resolution that’s actionable and not too hard to do

Easy and fun is my approach to New Year’s resolutions, none of this cold showers and swimming in the sea. My aim is for the amount of tax taken in the 2012 P60 form to be less than the one in this year’s April form. That means I have to understand Osborne’s shenanigans in changing the basic rate and HRT thresholds. The first time I tackled this, in 2009, my aim was to pay no tax at all so I forced my pay down to close to the £6,500 p.a. that matched the tax threshold.

Athough I could live on this, I found it massively got in my way as far as investing in the business and funding my ISA so I became less hard-line on tax reduction. It was, however, good in the first six months to see a monthly tax of £8.70 rather than the figure I had been used to.

Now I probably need about £15000, to be able to fund my ISA and maintain running costs. Unfortunately I can’t see a way of funding the ISA without paying £3,000 tax on the money earned to go into it.

Everybody wants to pay less tax. And it can be done – but not while spending everything you earn. Therein lies the secret…