Welcome back, as promised this week is the second part of a two part mini-series on personal finance. This episode is about tax efficiency, that is, one of the most important things to get right if you're serious about building wealth as an employee (and keeping it). This is going to be extremely UK specific, so if you're more of an international reader then please forgive my ignorance of your accounting practices, but maybe this will still be useful if you decide to relocate to the UK, or have similar accounts/rules/etc wherever you are.
Lets start at the beginning with how tax works at a basic level. We'll be focussed on pay-as-you-earn (PAYE) income, which is what most people have as their primary source of income, paid by an employer every month straight to their account. You will receive payslips which will detail your gross and net amounts, and as you ascend the pay scale you will find that a higher and higher portion of your hard earned pounds will be diverted towards the boogeyman of personal finance - income tax. I want to be clear here that I have no issue with paying tax, on the contrary, it (usually) goes towards improving society and providing essential services for the country. I'm interested in paying the exact amount of tax that the system is set up to extract, that's what this whole episode is about.
Income tax is a bracketed tax, meaning you pay nothing up to a certain amount, a bit more on anything between that amount and a bit more (the bracket), and a bit more still on even more than that (and so on) up to 45% in the highest bracket. It's extremely dull and there are some gotchas to be aware of, but the takeaway here is that there's a magic number around 120k past which you start donating the largest portion of what you're making to the British government. As a personal finance enthusiast you should aim to minimize your exposure to this bracket, since you're aiming for maximum reward for your time spent working.
So, how do you reduce your exposure to income tax? There's really only two mechanisms which could work, the first is just to earn less money (hmmm), and the second is salary sacrifice, which diverts income from gross PAYE straight into your workplace pension. This sacrifice into your pension is tax free, but the caveat is that you can only do this up to 60k/year total , or more specifically 180k across any three years. The second caveat is that since it's a pension, you leave yourself at the behest of whoever the current chancellor is - who may for example increase the pension age, retrospectively change the rules (as they have in the past), and any other fun things. That said, the salary sacrifice mechanism is extremely powerful. For example, if you earn over 180k and choose to sacrifice the full 60k for a given year, you will save a total of 27k (45% of 60k) - very nice.
Some bad news for those of you bringing in more than that - you're going to have to take the hit (or look at other options like deferral through synthetic equity and that kind of thing), the main point is that it gets very much case-by-case from these numbers and up, and completely subject to your firm's rules and setups.
Unfortunately that's about all we can do in terms of cash coming in. If you're really interested in financial independence then I would suggest taking this approach, after all, if you do this for 3 years and invest the pension in to the global index, you'll be sitting on around 180k, which after 30 years at 8% (low estimate) would sit just over 1.8M (if you make no further contributions over the 30 years!) - and just for fun at 10% it would reach almost 3.2M. Even after the robot uprising and avocados cost $50 each, that's not bad.
So now you're paying the exact amount of tax you need to based on your income, but it's important to thing about the other end of the equation; cashing out. The British government, financially savvy as they are, have set things up so that outside of specific accounts you may be exposed to capital gains taxes on the growth of your assets, which will eat away at the amount you get after your investments have grown and you're looking to buy pina coladas on the beach. After all, the only thing better than taxing things once, is taxing them twice, right? 🥲
So, the key account to be aware of is called the Stocks and Shares ISA. It's a special type of investment account which you deposit 20k/year in to, but which crucially you don't pay any tax on gains made within that account. This is in contrast to a regular investment (trading) account, the gains in which you will be exposed to capital gains on. Like all things related to tax there are caveats, but as a general rule, put as much as you can (up to 20k) in to your Stocks and Shares ISA every year (starting on the 7th April), and treat it like your ' invested cash under the mattress'. Do not withdraw it (since if you've already deposited 20k that year you can't put it back), and don't treat it as a regular bank account. The deposit limit paired with the tax free nature means this should be the last account you pull money from before your pension. In fact, it's actually sligthly stronger in terms of tax efficiency than your pension account since you may pay tax on pension withdrawals, but will never pay tax on ISA withdrawals.
You'll notice that I haven't mentioned anything about 'saving for a rainy day' or any kind of 'emergency fund'. That's for two reasons, the first is that I subscribe to the 'single thesis' rule, in that there is one (and only one) best* way for you to reliably build wealth. From my time on earth so far I believe that to be index funds, but you may disagree and that's okay. What this rule really means is that when I take a birds eye view of my finances, every account, every number, the question is always the same; could this be growing more? If the cash isn't in the global index then the answer to me is yes. The second reason is about liquidity, that is, how easy is it to turn 'value' in to 'cash'. I know for example that I can log in, issue a sell order, and withdraw funds to my bank account in around 5 days. This means that I can use this mechanism in an emergency, which in the context of the 'single thesis' rule means that rather than having for example $5k in a savings account at 3.5%, I have a very small savings account (enough for a flight and hotel anywhere) and essentially everything else is in the global index. This isn't directly related to tax efficiency, but it does help frame my thinking in terms of what to contribute to which account, and how things look when it comes to cashing out.
The last thing I wanted to mention is about debt and taxes. There are some other techniques you could do (which I don't personally do), depending on your risk apetite and overall financial vibe. A good accountant may advise you to set up a company through which to deal your personal assets. This is good for the bigger leagues (incoming cash flow of over 200k/year or more plus say 250k+ net worth) in terms of tax efficiency, but naturally adds a bit of complexity. Another thing to mention is 'stoozing'; as your income increases you'll find that banks are increasingly open to lending you more and more money. The most attractive of which is called 'balance transfer credit', which if you can find one at say 0% for 12 months means you can open e.g. a 10k line of credit, transfer it all as cash, invest it into the global index, then sell it in 12 months time and pocket the difference. You can also use these cards to minimize any other debt repayments, but from the last episode your mission should be to completely eliminate personal debt. From some quick napkin calculations stoozing natually becomes more and more worth it the larger the amount you can transfer becomes, but as any kind of debt you're betting that the global index will perform better than 0% (or whatever it is), which historically hasn't always happened. If you land on the wrong side of this bet you'll have to eat the loss, which if it has to come out of your ISA would be a disaster.
In life and in taxes I avoid complexity, so haven't opted for any of the debt based approaches above, but wanted to mention them since it's always good to know what's possible.
When I was proof reading this one I realised I didn't include anything about tax residency, that is, the country to which you pay your taxes. Almost everyone reading this will not be able to change their tax residency due to other life commitments, relationships, mortgages, and that kind of thing. But for anyone looking to really go off the deep end when it comes to tax efficiency, there is no doubt that changing (or completely removing) your tax residency is the way to do it. The high level vibe is as follows; your tax residency is usually tied to the country you spend most time in during the year plus your citizenship (this is a huge simplification but bear with me). However, when visiting other countries they have specific time thresholds (usually 180 days) out of a year at which point you become a tax resident in that country. For example, I was recently in Vietnam for 3 months, if I were to go back right now for another 3 months, I would qualify as a tax resident in Vietnam and therefore be exposed to their tax regime. This means that if you spend a maximum of 179 days every year in whichever country you're in (say pick 3 and move between them every quarter), then you'll never qualify as a tax resident anywhere, and will therefore not pay income tax anywhere.
This is a bit of a simplification but the core idea is to detach your tax exposure from your lifestyle, essentially becoming a truly international person. With a bit of legal help to make sure you're properly detached from your 'home' country, this is the most powerful approach. However, keeping a job, running an international company, or otherwise managing investment accounts taking this 'ultra-globalist' approach brings its own challenges, but that's for another episode.
Anyway, that's all for my beginners guide to tax efficiency. In short: pay what you must, use available protections generously, and do more spicy things as your taste allows. I hope this was useful, and next week we'll be back to regular programming, and then Georgia in review!
Thanks and all the best,
Oliver
* best in terms of risk, reward, and cost for you
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