Before we begin.....
Our goal is to help people maximise their investment returns after taxes. Most of our posts focus on the maximising returns part. However, being smart around tax planning is also very important. We use some of the strategies below for our own personal investments to reduce our P2P taxes. However, we need to be 100% clear that we are not tax experts, and we cannot provide formal tax advice. Please consult your tax advisor on any of the strategies outlined below. The rules in each country can also vary significantly. Our goal is to highlight some strategies that many investors are already using that could shave thousands off your future tax bills.
The strategies below are fairly specific to UK taxpayers. However some techniques and strategies will also work further afield.
#1 - Make sure you are fully using the tax allowances of your partner
Did you know that in the UK, an individual can earn up to £17,000 of interest income without paying any taxes at all? We won’t go into all the details, but the UK government website has more details here.
Unlike countries such as Germany, the UK doesn’t allow married couples to pool their tax free thresholds. If your partner has a lower income, or zero income, it is tax efficient to make P2P investments in their name to reduce the tax burden on the higher rate taxpayer.
How does this work in practice?
If you have a joint bank account, it is very easy to set up a P2P investment account in the name of your partner (with their permission of course), as long as funds are wired from the joint bank account. This will usually be sufficient to comply with the various legal requirements. Some platforms, such as Bridgecrowd, even allow you to operate a master account, and operate various sub-accounts on behalf of other family members. This allows you to make loan purchases on their behalf.
What are the downsides?
The obvious potential downside is that it may or may add extra complexity if there is a breakdown in the relationship between the provider of the investment funds and the person whose name the investments are made in….. Your call….
#2 - Cut your P2P taxes using tax free savings schemes such as IFISAs
What the £$? is an IFISA? It stands for Innovative Finance Investment Savings Account. Most British taxpayers are already aware of ISAs, but these accounts have historically been restricted to cash deposits or equity investments. IFISAs were designed to expand the investment possibilities into P2P investments. IFISAs allow investors to invest up to £20,000 per annum into P2P annually. Some, but not all British P2P platforms offer an IFISA ‘wrapper’ on their investments. In many cases, investors will need to pay a fee of around 1% pa for the management costs associated with the wrapper. However, all future income earned on the investment held within the IFISA account is free from income taxes and capital gains taxes.
This seems a bit expensive and a bit of a pain, is it worth it?
If you are looking to invest long term, and are a taxpayer in the UK, we think this is a ‘no brainer’. Why? Let’s run some numbers…..
Let’s assume you have £20k to invest and have an investment horizon of 15 years. You expect to generate returns of 8% pa but you will need to pay a 1% management fee to receive the IFISA wrapper.
If your marginal tax rate is 45%, the IFISA will save you over £17,000 in taxes and lost compound interest over that period (almost as much as you invested). The future value of your investment after all taxes, and IFISA management charges, will be 44.6% higher than doing it outside of the wrapper.
If your marginal tax rate is less than 45%, the tax savings will be less but still very significant over the long term, as long as you pay at least the basic tax rate. Also keep in mind that the £20k limit is available to every adult, so a total of £40k can be invested per annum per couple, which is a significant tax benefit.
We will shortly be doing a post on the best platforms offering IFISA wrappers.
#3 - Investing via a company can significantly cut your P2P tax bill
We already know what your thinking…..That’s going to be a total pain and be very expensive. Hear us out…..
Establishing a company is extremely inexpensive in the UK. In fact you can have one set up within hours for around £10 through services such as rapidformations. The two main housekeeping requirements are to file annual statements with companies house, and a tax return with HMRC. Many investors will be able to file this without assistance, but you may prefer to engage an accountant to do so.
What are the benefits?
The biggest benefit, particularly if you are a higher rate taxpayer, is from paying tax on income at the lower company tax rate. The difference is currently very large – 19% for the current company tax rate in the UK versus the highest marginal personal tax rate of 45%. Over time, the compounded effect of this difference is extremely large.
Let’s assume that a taxpayer has used up all their IFISA allowances and would otherwise have to pay a marginal tax rate on their P2P earnings of 45%. The taxpayer has an expected return of 8% pa on a £50k investment over 15 years.
If the taxpayer invested £50k via a company and paid annual corporation taxes on income then the value of the company would be worth £128k in 15 years time. If the investments were held by the taxpayer, and subject to income tax, the value of the investment would be £33k less, or £95k.
Note – if the company was to be wound up, the taxpayer could be subject to capital gains taxes on the liquidation value of the company versus the amount invested. The calculations can be complex and are beyond our scope. But we highlight that currently, there are very generous capital gains tax annual allowances, and capital gains tax rates paid on gains in excess of these allowances are low relative to income taxes. We have no way of predicting what the tax rules will be in 15 years, but under the current rules, investing via a company structure would generate significantly higher returns for taxpayers in the 40 and 45% tax brackets, even allowing for CGT upon wind up of the company.
Other benefits of investing through a company
One of the less obvious benefits of building wealth within a company structure is the ability to defer income until a later period when a taxpayer may be subject to lower, or zero taxes. This is often most relevant for people approaching retirement. Investors who plan to leave the UK at some point may also see significant benefits, as they are not generally subject to UK capital gains taxes once they have left the country for 5 years. The most savvy tax planners might choose to be resident in a country that does not tax foreign capital gains once this 5 year window closes….Many of which have quite good golf facilities and are much warmer….