If you have ever received any income, you are at least somewhat familiar with taxes. Many people who hold salaried, full-time jobs as their sole source of income may simply know they pay taxes on their income and at the end of the tax year, they may receive a tax refund from the government if they happened to pay too much.
For most people, the legwork is all completed by the employer and there is little individual citizens must do to ensure they comply with the laws. However, those who own businesses (either as sole income or as supplementary income), those who have any kind of investments, and those have high incomes have to be more active when filing taxes. These people need to file self-assessment tax returns.
Tax Rates and Exemptions on Investments and Trades
These may defer by country but in the UK there is a progressive tax system: residual money earned is taxed at a higher rate. This does not mean the entire amount is taxed at a higher rate, but that any income over the threshold for the tax bracket is taxed at the bracket’s rate. The UK also implements various tax rates for different types of income.
The numbers defining the brackets changes periodically, as does the allowance for the tax-exempt portion (which can effectively be thought of as a 0% tax bracket). There are three brackets: basic, higher, and additional.
We will discuss the four main taxes for retail traders and investors below.
This is the rate paid for wages, but it also includes capital gains earned through short-term investments under certain circumstances. That means traders who enter and exit many positions quickly will incur income tax rates on their profits if they are treated as a business. If you are a full-time trader, you may have to pay the high-income tax rather than capital gains tax.
The income tax brackets for the UK (ex. Scotland, which has its own scheme) for 2018-19 are as follows:
|Personal Allowance||Up to £11,850||0%|
|Basic rate||£11,851 to £46,350||20%|
|Higher rate||£46,351 to £150,000||40%|
|Additional rate||over £150,000||45%|
Source: UK government, which also publishes past rates.
The dividend payment rate is different from the income rate. If you have dividends, they are not considered “income” for taxation purposes, but rather “dividend income”. These are taxed according to the tax band under which they fall as follows:
|Tax band||Tax rate|
Source: UK Government
Similarly to income tax, the dividend tax has an allowance, and it tops out at £2,000 for the 2018-2019 tax year (it was £5,000 previously). This dividend allowance can be combined with the personal allowance, so each tax situation is different. It is completely dependent on how much income you have and where it is generated. See this publication for some examples.
Capital Gains Tax
This is the amount paid on any capital gains – which must be considered non-trading income to be eligible for capital gains taxes. Investments are eligible for capital gains taxes, and the rate is 10% for the basic tax band and 20% for the higher and additional tax bands. These rates are for individuals and are applicable to stock market investments. Other rates and allowances apply to different situations.
There is also an annual exemption for capital gains, which will be £11,700 for the 2018-2019 tax year. For those running businesses or making major investments in businesses, there is the Entrepreneur Relief scheme, which taxes all eligible capital gains at 10% up to £10 million.
Stamp Duty Tax
One tax that is not directly related to income is the stamp duty tax. This is based on the amount of the transaction, and the more often you transact, the more you will pay in this tax. It is set at 0.5% of the transaction amount. This is applicable to all electronic transfers of shares, but if you receive paper stock certificates, it is only applicable to purchases over £1,000.
A maze of legislation exists for taxes, and of course, there are exemptions to the above rules. If you think you have significant amounts to gain from exemptions or fall into the higher tax brackets, it may be worthwhile to speak to a tax accountant.
One exemption is on winnings, which includes gains from spread betting. Since this is considered a form of gambling, and gambling winnings are not taxable in the UK, there is no tax to pay for them.
For some high-growth securities, there may be no stamp duty tax. Contracts for Difference (CFDs) are also exempt from stamp duty, even if the underlying asset is subject to the tax because the CFD holder never legally owns the shares.
Should you pay attention to tax implications?
The short answer: yes. If you can save any money that would otherwise be paid in taxes, it increases your annual return and puts a little more cash in your pocket (or your trading account). For companies, it makes sense to defer taxes because they essentially receive an interest-free loan (by virtue of not having to borrow cash at interest to finance activities otherwise financeable from money to pay future taxes). And of course, big-name investors like George Soros and Peter Lynch consider the tax advantages of moving money to charities and foundations to avoid major tax bills.
Tax implications are not the primary consideration since tax burdens are based on income and capital gains earned. Your primary consideration should certainly be making the best, most profitable trades and investments possible, focusing on industries you know well. However, the type of investment you make can be important, and if taxes are sufficiently high, they may alter the investment strategy.
So while tax considerations should be incorporated into a trading or investment plan, they are not the main considerations. On the other hand, one cannot ignore tax implications, either.
An example of dividends versus high-growth
If you invest in high-growth securities, you may qualify for stamp duty tax exemption and you can earn £11,700 tax-free. On the other hand, if you are focused on low-growth stocks to collect dividends, you can only collect £2,000 of dividends before you must pay taxes. Thus if you earn £11,500, you may owe no tax or you may owe tax on £9,500. Let’s say you fall into the basic income range, then you will owe 7.5% on that £9,500, or £665. That’s not a particularly large tax burden, especially considering the capital required to generate £11,500 in mature-stock dividends.
But let’s consider £40,000 in dividends versus £40,000 in capital gains. Assuming this is in addition to your salary, you are likely going to fall in one of the top tax bands. If your salary is also £40,000, you will be paying 32.5% tax on 38,000 in dividends (£13,000), while only £29,300 of the capital gains are taxed, and they will be taxed at 20% (£5,860). At £80,000 yearly income, this amounts to nearly 10% of your income, a non-negligible amount.
Stamp Duty For Traders
For traders whose main source of income is trading, your trades will be considered wages and taxed as such. If you make a profit, this can quickly become a major burden on your earnings. But you can predict your expected income and prepare for this annually-charged tax.
The stamp duty tax is something every trader must consider. Since it is levied for every trade of shares, profit margins on trades must at least exceed the stamp duty tax and trading costs. Absolutely gains on trades must effectively be above 0.5% to be considered a profit for the trader at all. Investors should also incorporate the stamp duty tax into calculations, but generally, investors hold their investments for longer terms and bigger gains, whereas day traders or swing traders might eke out profits of 0.5%-1% per trade.
To avoid the stamp duty tax, traders may find other investment vehicles more attractive (those that do not grant legal ownership of the underlying). Contracts for Difference might be one such vehicle. Traders may also be interested in trading methods like spread betting since it won’t incur any taxes at all.
The stamp duty tax exemption may seem like small concession in the face of large income tax burdens, but it can incentivize investors and traders to purchase high-growth stocks over dividend-paying ones. Not only is the stamp duty retained, there is a much high allowance for capital gains than for dividends.
If you are focused on building an estate for retirement or you are not an active trader, tax-advantaged strategies are quite useful. To encourage consumer saving and responsible financial planning, the UK government allows individuals to store revenue-generating capital in tax-free accounts. The Individual Savings Account (ISA) is the UK’s tax-advantaged investment and savings scheme (for our American readers, the US version is an IRA or Roth IRA with differences).
The ISA contribution for 2018-2019 is £20,000, and there are four types of accounts: cash, stock, innovative finance, and lifetime. Interest, income (from dividends), and capital gains from the investments residing in an ISA are non-taxable. In contrast to the American IRA, the money is never taxed (at generation or at withdrawal) and withdrawals can be made at any time (there’s no waiting period). You can contribute (deposit) up to the £20,000 limit.
It should be noted that many ISAs are not “flexible”, so if you withdraw the deposit or generated the income you do not reduce the contribution limit. So while you can withdraw the earnings generated right away, you might not change your remaining contribution limit or be able to return the money to its tax-protected status. So only withdraw large amounts if you plan to spend it – otherwise, it is better to allow it to continue to generate tax-free income.
Trader or Investor?
The differences in taxes for traders and investors can be stark. Using just the difference in capital gains and wages tax rates, there can be a major difference, especially as income rises: traders will pay the higher 32.5% or even 45% while investors with the same income would pay a mere 20% if high profits are registered. Investors will even avoid significant stamp duty tax. Moreover, the trading activity might not qualify the gains for the capital gains allowance, adding further tax burdens for traders. At first glance, it seems trading is highly disadvantaged.
However, because trading would be considered operating a business, there are many more tax deductions available, even including items like rent or bills. So having a full-time job and simultaneously considering your trading activities a business may actually be tax-advantageous if you have a lot of deductions for operating the business. Of course, certain patterns of activity will also lead to a particular classification, though the classification is somewhat subjective, particularly for fringe cases.
The way in which taxes are applied varies substantially from individual to individual. Mixed income individuals will have the most complex tax burdens, and while tax considerations should be taken into account when developing a trading or investing strategy, it should not take a precedent over the earning potential and metric-based merits of the actual investment or trade.
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