The Two Phases of Wealth Building

Every week I religiously capture the value of each of my investments which I then sum to give me an instantaneous net worth.  This week saw my net worth increase by more than £5,000 without contributing any new money.  For me that is a very large amount of money, and of course Mr Market could take that £5,000 away this week, but it reminded me of the two phases of wealth building that I'm seeing as I'm working to build wealth over a quite short period of time.

The first phase is Building Capital.  As you start on your wealth building journey this is the first phase you pass through.  Here you just want to be adding as much capital to your wealth as quickly as you can get your hands on it.  Saving Hard by Earning More and/or Spending Less will have a much bigger effect in this phase than Investing Wisely.

The second phase is Return on Capital.  Here while Building Capital is still providing a big boost to your wealth it’s now more important to have a stable investment strategy which is very tax and investment expense efficient.  In this phase you could even start to ease of the Saving Hard by for example going part time or taking up that lower paid higher enjoyment opportunity you’ve always desired without moving your financial independence day greatly.

Let me demonstrate the two phases with a simple example (where I’ll ignore inflation) that tries to cover many of the points that I personally live (and have lived) as well as regularly capture on this site.  Average Joe works hard and for his hard work receives £45,000 per year making him a 40% higher rate taxpayer.  Joe wants early financial independence to give the option of early retirement and so starts to think about he might achieve that.  He realises he firstly needs to focus on Building Capital by Saving Hard.  His employer offers a pension scheme where if Joe salary sacrifices 5% of his own salary then they will match it.  There’s some free money there so he goes for it.  Salary sacrificing also brings the benefit of lowering Joe’s taxable salary to £42,750 saving both employee and employer National Insurance.  Joe’s employee NI saved is added immediately to his pension but his employer also generously adds the 13.8% employer NI that they also save.

Why Using Your ISA Allowance Every Year Is So Important

We are now less than 2 months away from a new tax year in the UK.  With that new tax year comes a new ISA (Individual Savings Account) allowance.  The Investing Wisely portion of my Low Charge Strategy requires me to continually work at minimising the tax paid to HM Revenue & Customs  which is partly achieved by maximising my ISA contributions and coming as close to the full ISA allowance every year as possible. 

Before we review why maximising contributions and preferably using the full ISA allowance is so important let’s first review the basics of ISA’s:

• An ISA is nothing more than a wrapper that surrounds purchased assets such as cash and shares.  Its primary purchase is to shield you from taxation.
• There are two types of ISA.  The first is a Cash ISA where you can contribute up to £5,640 in the current 2012/13 financial year.  In the 2013/14 financial year the allowance will rise to £5,760.  The second is a Stocks and Shares (S&S) ISA into which you can contribute £11,280 less any contribution made into a Cash ISA this financial year.  In 2013/14 the S&S ISA allowance will rise to £11,520.
• Contribute refers to the total amount of money you can pay into the accounts each year.  For example it is allowable to contribute £11,280 into a S&S ISA and then withdraw £3,000.  What isn’t allowed is to then add that £3,000 back into the ISA within the same tax year.
• Current government policy is that the annual ISA subscription limit will be increased annually by the Consumer Prices Index (CPI). The increased limit will then be rounded to enable punters to make regular monthly payments in round terms. If the CPI is negative then limit will not be reduced but will be left unchanged.
• Any savings in a Cash ISA can be converted to a S&S ISA but you can’t convert a S&S ISA into a Cash ISA.
• You don’t pay any tax on interest received with a Cash ISA.
• You don’t pay any tax on dividends received within a S&S ISA.  If you’re a 20% (basic rate) tax payer then in theory the ISA offers no advantage because 20% tax payers don’t pay tax on dividends.  If you’re a 40% (higher rate) or 45% (additional rate) tax payer then you get a big advantage because if you’re saving outside of an ISA your effective tax rate on dividends are 25% and 30.55% respectively after allowing for the dividend tax credit.  ISA’s therefore offer higher and additional rate tax payers a significant advantage however I also believe that basic rate taxpayers should also take advantage.  The reason is because you never know when you will be a higher rate taxpayer plus you also never know when government will start to apply tax to dividends received by basic rate taxpayers. 
• You don’t pay Capital Gains Tax within a S&S ISA.  If you’re outside of the ISA wrapper then UK taxpayers receive an Annual Exempt Amount (£10,600 in 2012/13) however after this then you’re up for tax at 18% or 28% depending on your taxable income.  So ISA’s save basic rate, higher rate and additional rate taxpayer’s tax.  You may think that you can invest outside of an ISA and keep capital gains tax within your annual exempt amount by controlling when you sell but remember corporate events outside of your control like takeovers and share swaps can trigger capital gains tax events.  Within the ISA you have nothing to worry about.
• A time advantage is that you don’t need to keep records for tax reasons and because you can ignore anything within an ISA for tax reasons then filling in your annual tax return is greatly simplified. 
• It is a use it or lose it allowance.  So if you only contribute £10,000 to a S&S ISA this year then that’s it. You never get another chance to contribute that £1,280 of unused allowance.  It is lost forever. 

The last point is critical and shouldn’t be underestimated.  It is a mistake I have made and which is now impossible to rectify.  I was naive and for a number of years never even considered ISA’s.  Then when I did eventually understand a little about them I thought I’m just a basic rate taxpayer so they won’t help me.  Roll on a few years and hard work resulting in a few promotions plus bracket creep (inflation pushing income into higher tax brackets) has resulted in me becoming a higher rate taxpayer.  It’s a mistake that is now impossible to rectify because I can’t roll back the clock.  The vast majority of my savings will be used for my Early Retirement (some will be used to buy a home when value returns) meaning that I will possibly be paying for that mistake for the rest of my life.

Tax efficient investing – 2009/2010 Individual Savings Accounts (ISA) year end fast approaching

This post is a reminder that the 2009/2010 individual savings account (ISA) 05 April 2010 year end is fast approaching. If you haven’t already taken full advantage of your annual ISA allowance then you may want to investigate now before it’s too late. Once the year ends the opportunity is lost forever. As a mid 30’s investor I have taken full use of my allowance of £7,200 already this year by investing within a stocks and shares ISA.

Tax efficient investing – Individual Savings Accounts (ISA’s)

To ensure that I maximise the annual return on my retirement investing strategy I am constantly focused on three key elements:
1. Ensure I have the right asset allocation in place
2. Minimise the fees that I pay by buying index linked investments wherever possible
3. Minimise the tax that I pay

To minimise the tax that I pay I use one tax friendly investment and two tax wrappers.
I have written in the past about the tax friendly investment I use to help me minimise tax – Index Linked Savings Certificates.

Today I’m going to talk about one of the tax wrappers I use which is Individual Savings Accounts (ISA’s). The other tax wrapper I use is a personal pension which I will discuss in the not too distant future.

I’m not going to go into great detail about how ISA’s work as most people are aware of them and you can find plenty of information on the internet including here.

My current retirement investing strategy holds around 9.7% of its assets in Stocks and Shares ISA’s. I do not use Cash ISA’s at this point in time. Providing that you find a Stocks and Shares ISA provider that does not have any fees for the privilege of using the ISA tax wrapper I cannot find any negatives to using them. At the very worst you are break even and neither better nor worse off.

For me the Stocks and Shares ISA is performing a powerful function. To minimise fees for some of my asset classes I am buying offshore based exchange traded funds (ETF’s) which are categorised as non-distributing funds by HM Revenue & Customs. In very crude terms if I was not holding these within the ISA and I chose to sell to rebalance my portfolio the capital gain would be taxed as income rather than as a capital gain. This also means that I could not use my capital gains tax allowance either. As all income (dividends and interest) and all capital gains are tax-free within an ISA I am sheltered from this problem.

As always DYOR.