In 2017/18, Capital Gains Tax (CGT) brought in £8.8 billion for the exchequer. While this amount may be small fry compared to the revenue generated by other taxes, it’s still a valuable source of income to the Treasury.
Earlier this year, the government asked the Office of Tax Simplification to undertake a review into CGT as part of a wider programme of potential changes that may be needed to pay for coronavirus support measures. This report was published in November 2020.
With potential changes to CGT in the pipeline, it’s a good time to focus on how you can utilise the valuable annual tax-free allowance on capital gains.
More about your annual CGT allowance
When looking at maximising tax allowances, one exemption that often flies under the radar is the annual Capital Gains Tax allowance.
This allowance lets you make a certain amount of gain each year before you have to pay tax. Nearly everyone who is liable for CGT gets the allowance, including trusts.
The Annual Tax-Free Allowance on capital gains in the UK is £12,300 in 2020/2021. That’s £2,460 of future Capital Gains Tax (CGT) that can be eliminated every year if the right amount of gain can be released from your portfolio.
It’s important to remember CGT is only paid on gains. CGT is a tax on the profit when you sell (or ‘dispose of’) an asset that has increased in value. It is the gain you make that’s taxed, not the amount of money you receive.
Most commonly, these assets refer to second homes, shares and commercially dealt antiques, rather than personal possessions, gifts, or private cars.
Of course, gains are ultimately what investing is all about. However, as an investor, Capital Gains Tax is like the velociraptor chasing the children through the kitchen in Jurassic Park – you can only run for so long before you need a plan and a strategy.
Why you should consider crystallising gains
As an investor, your CGT allowance is very much an annual ‘use it or lose it’. Ideally, therefore, you should ensure that the full £12,300 is ‘harvested’ from your total gains in any given year. If it isn’t, you could just be kicking a tax can down the road.
You have to accept that CGT must be paid at some point in the future – and if some of that tax comes sooner rather than later, then so be it. It’s essentially an argument between emotions and maths.
- If you crystallise gains now, use your annual allowance, and pay CGT at 20% you have less in the account post-reinvestment
- Or, you could have a larger amount invested but you’ll be pregnant with CGT.
We recently undertook some research which revealed that, unless investors are holding to death, the numbers suggest individuals should consider crystallising gains now if they are able to do so, use their annual allowance, and take the hit.
In addition, the compound effect of using an annual CGT allowance is significant, and so the allowance should be utilised in dealing accounts, where available, each year.
There is certainly a case for realising gains while the tax rate is 20%. Of course, everyone’s circumstances are different and so we recommend speaking to us before making any decisions in this regard.
CGT rates set to rise in the future
One reason we believe it can pay to crystallise gains each year is that it looks inevitable that CGT rates will rise further.
While the Office of Tax Simplification’s recent report stops short of recommending that Capital Gains Tax rates mirror those for Income Tax, it does refer to rates being ‘more closely’ aligned.
The report suggests that the differential in rates encourages people to convert income into capital gains. It also suggests that an alignment would simplify the tax rules as there would be no need for complex anti-avoidance provisions policing the boundary between income and capital gains.
Currently, the full gain (with no adjustment for inflation) is added to your income to determine the rate of tax which will apply. This is currently 10% and 20% on non-residential assets and, 18% and 28% on residential property. In 2017/18 the average rate of CGT paid was 15% – well below the Income Tax rates.
If the government aligns CGT and Income Tax rates as part of a package of reforms, you could pay 20%, 40% or even 45% tax on gains. It’s worth noting here that people who pay CGT are twice as likely to be higher rate taxpayers than those who do not.
This is another powerful reason why it could be better to crystallise gains annually now. The worst-case scenario currently is that you’ll pay 20% CGT on investment gains whereas, in the future, this could be 40% or more.
As the Chancellor may not want to usher in a series of tax rises now, what is perhaps more likely in the short term is that we will see a change to the annual exemption.
The annual exemption currently allows chargeable gains of up to £12,300 each year. As we have seen, it is an effective way of limiting the gains payable on an investment portfolio by ensuring sufficient gains are realised each year to utilise the allowance.
It is currently worth up to £2,460 a year for a higher-rate taxpayer. And, if you repeat this exercise each tax year, the tax savings can have a significant impact on your net investment return.
The OTS report concludes that, if the purpose of the annual exemption is to simplify administration by taking out of tax those individuals who realise small gains, a more realistic level would be somewhere between £2,000 and £5,000.
While this would result in around 300,000 to 400,000 more individuals having to pay CGT, any additional tax would fall mainly on wealthier individuals – which may be politically attractive for the government.
This proposal is yet another reason why it may be beneficial to utilise your annual exemption while it remains at the current level.