Making money while avoiding tax is the name of the game. We’re always trying to maximise our salaries and investments while minimising our personal taxes. But this raises the question: from a tax perspective within your investment portfolio, is it better to generate income through dividends or make money through capital gains?
While there is no black and white answer, and the answer can vary based on a person’s personal needs and obligations, financial advisers agree that it’s easier to avoid taxes via capital gains.
“For the vast majority of people, everything else being equal, capital growth is more tax efficient,” says Scott Taylor, an independent financial adviser (IFA) at Brilliance Financial Planning.
“Very few people use their capital gains annual tax exemption,” says Taylor.
This annual capital gains tax exemption is set at £10,600 for the 2012-2013 tax year, which means individuals across the UK can make up to £10,600 in capital gains this year without paying any tax. But this tax exemption only applies to gains made after selling or giving away your investments, such as stocks and funds. Investors cannot use the capital gain tax exemption to shelter money made through dividend payments.
As a general rule, if you’re making a decent salary in the UK, making money via capital gains is more tax efficient than making money through dividends, says Martin Bamford, a chartered financial planner and managing director at Informed Choice. He calls the capital gains tax exemption a “major unused tax relief”.
If you are lucky enough to have realised capital gains above and beyond the £10,600 tax-free limit, then the other gains will be taxed at either a rate of 18% or 28%, depending on your level of income. This generally tends to be a more favourable rate compared to the tax on dividends, says Bamford.
But for those investors who use a buy-and-hold strategy, realising capital gains each year is not easy since they are focused on buying and holding, not selling each year to realise capital gains. In cases such as these, Bamford says capital gains can still be realised when people rebalance their portfolio each year.
For those who are looking to retire soon, once you reach the age of 65 and then 75, you will receive a higher personal tax allowance for dividends and income. This makes dividend-focused investing more tax efficient for people in their later years, says Bamford. However, Bamford says he expects that over time the government will phase out this tax relief. Therefore, anyone currently under the age of 50 shouldn’t count on these tax allowances going forward.
While realising capital gains is generally more tax efficient for working individuals compared to dividends, Taylor says that investing in dividend-paying funds and companies is still very important for your overall investment strategy. Dividend investments are generally more dependable and steady, which makes them highly desirable for investors, he says.
“If you had an investment policy that’s predicated [solely] on capital returns over income, that’s dangerous,” he says. “Over the long term, income is a significant driver of investment returns. And you ignore that at your own peril.”
This article was originally part of Morningstar.co.uk's "Seeking Income Week" series from July 2012.
