How to maximise after-tax returns from savings

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Donald-Drysdale By Donald Drysdale for ICAS

22 February 2016

At a time when taxpayers ought to be looking carefully at their exposure to tax on savings, Donald Drysdale finds food for thought in a new IFS report.

The Institute for Fiscal Studies (IFS) report ‘Effects of tax and charges on savings incentives’ published on 16 February contains daunting statistical detail.

However, it comes at a time of change in the UK tax treatment of income from savings so is well worth reading.

As the IFS explains, savers face a complex and changing array of different tax treatments. These differences are substantial and can make choosing the ‘wrong’ savings vehicle a very costly mistake. Furthermore, variances in fees and charges may outweigh the effects of differing tax treatments.

Why is this relevant now?

New regimes for taxing interest and dividends will be introduced this April. Restrictions on interest relief for buy-to-let housing are being phased in from next April. Universal credit is being rolled out, bringing a significant change in approach to means-testing for benefit purposes. And there are rumours that the Budget in March may announce changes to the tax treatment of pensions.

What taxes are considered?

When measuring the effect of tax on savings returns, the report considers income tax, national insurance contributions and capital gains tax. It excludes corporate taxes and stamp duties, and does not consider savings for bequests (and therefore inheritance tax).

The exclusion of corporate taxes seems logical; they are clearly one step removed from decisions to invest in companies. The reasons for disregarding Stamp Duty Land Tax (SDLT) and Land and Buildings Transaction Tax (LBTT) in relation to owner-occupied and buy-to-let housing are less obvious; after all, the quantum of these varies with the investment strategy, depending on the value of the assets acquired, the use to which they are put and the frequency of replacement, with a significant supplement payable on additional residential properties acquired from this April.

Methodology used in the report

Methods of saving are categorised according to whether key components – the income saved, the returns on the savings, and the funds ultimately withdrawn from saving – are taxable (T) or exempt (E). For example an interest-bearing bank account is described as having TTE tax treatment, because savings are made from taxed income, interest is also taxed, but withdrawals are not taxed. By contrast, an ISA is TEE and pensions are predominantly EET.

For the mathematically inclined, the report uses two measures of tax on savings returns. First, the effective tax rate (ETR) is the percentage point change in the annual real rate of return on the asset due to taxes, expressed as a proportion of the real pre-tax return – using a TEE saving (such as an ISA) as a baseline of zero. Second, the ‘required contribution’ is the amount one would have to invest in each asset to match the final wealth from investing 100p in the TEE benchmark. For more technical detail, the report is essential reading.

Tax year 2015/16

The report highlights wide variations in how different savings are taxed in 2015/16, first for basic rate taxpayers; for them, savings in private pensions (for example under auto-enrolment) receive the most favourable tax treatment, followed by ISAs and owner-occupied housing (both untaxed relative to the TEE baseline), then rental housing and shareholdings, with bank accounts the least favoured. For those with higher marginal rates of tax (including those on the tax credits taper), incentives to save are generally weaker – except in the case of pensions, where the 25% tax-free lump sum is of greater value to these people.

Few individuals face the same marginal tax rate throughout their adult life, and having different marginal rates at contribution and withdrawal stages can dramatically affect the incentive to save in a pension. The effects of means-testing can be similarly profound – the report even suggests (perhaps unrealistically) that there is a strong incentive for anyone on the tax credits taper to contribute to a pension.

Tax years 2016/17 onwards

At current low interest rates the new personal savings allowance from 2016/17 onwards will leave few people paying tax on savings interest. Reforms to the tax treatment of dividend income will reduce tax for higher and additional rate taxpayers with modest share portfolios, while increasing tax for all taxpayers with large portfolios. For those with annual dividend income of £5,000 or more, the incentive to save more in shares (outside pensions and ISAs) will reduce.

The report emphasises that separate tax-free allowances for different purposes will favour individuals who can diversify their savings returns and time them carefully. Those who can fully use their nil rate bands for interest, dividends and capital gains, as well as their income tax personal allowance, will be able to receive around £28,000 a year free of tax, compared with £10,600 for those who can use only their personal allowance.

From 2016/17, buy-to-let housing will become significantly less attractive as an investment for higher rate and additional rate taxpayers who require mortgage finance, as a result of the phasing in of restrictions on tax relief for landlords’ mortgage interest. In some cases this will increase the incentive to invest in rental housing through a company.

It is widely expected that the Budget on 16 March 2016 will announce reforms in the tax treatment of pension contributions. It has been suggested that in future these might be relieved at a flat rate – or perhaps not at all in a scenario where the eventual pension could be tax free. Such changes would require fundamental reappraisal of the attractiveness of pensions as compared with other methods of saving.


Government policy allows individuals to save substantial amounts in a variety of forms with no tax on the savings return. However, frequency of change in recent years and uncertainty about future reform make it difficult for people to understand the rules and particularly hard to plan long-term retirement saving.

This IFS report has been prepared at a time of low inflation and exceptionally low interest rates. Should either of these factors change, it would be imperative to reconsider the rationale behind savings decisions and related tax planning.

Article supplied by Taxing Words Ltd

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