If the thought of investing leaves you feeling confused, you’re not alone. With terms like ‘dividends’, ‘arbitrage’ and ‘yield’, the world of stocks and shares and all its terminology can be overwhelming to the average person.
Not only that, but you need to consider the tax you might have to pay on your investments, which can make you wonder whether it’s worth the stress of dealing with all the extra paperwork for HMRC. This is especially true if you’re self-employed or run your own business, as you’ll know all about how painful submitting a tax return at the end of each year can be.
But with savings accounts currently offering such poor interest rates, it seems more people are deciding to invest in stocks instead. According to a recent survey, a third of Britons now own shares.
Investing in stocks can be a great way to boost your finances, but before you start going all ‘Wolf of Wall Street’, it’s important to understand the effect it can have on your tax bill.
How does investing in stocks affect taxes?
You may have to pay more income tax if the return from your investments exceeds your personal allowance of £12,570 for the tax year from 6th April 2021 to 5th April 2022.
You might also have to pay tax on any dividends you’ve received from being a shareholder of a company, and if you sell your shares and make a profit over a certain amount, you’ll have to pay Capital Gains Tax.
In this article, we’ll explain the different types of tax you need to pay on investments and give you some hints and tips on how to reduce your tax bill.
What are stocks?
Before we go into the finer details on the tax implications of investing, it might be helpful to first define exactly what stocks are and explain a bit about how the stock market works.
A stock represents a piece of a company. When you buy a stock, you’ll be a shareholder because you have a share in any profits the company might make.
Once a company is listed on a stock exchange, trading can start and the value of its shares will fluctuate, according to how much investors and traders believe them to be worth.
Why would a company want to go public?
There are a few reasons why businesses want to issue shares to investors. It could be that they want to raise capital in order to grow at a rate they wouldn’t otherwise be able to. To scale up they would need to buy equipment, hire employees and lease more workspace, for example. Or it could just be that they want to improve their public profile.
Should I invest in stocks?
That all depends on your tolerance for risk. Investors who take bigger risks when buying and selling shares can be rewarded with better returns – but they have to be prepared to lose that money too. If you’re a more conservative investor, you should consider choosing stocks that have a long history of paying dividends instead.
Do I need to pay taxes on stocks?
The simple answer is: Probably. When you sell stocks you’ll have to pay taxes on them, and you may also have to pay taxes on any dividends or interest earned. But we’ll go into all of that in more detail below.
Dividend tax
If you own stocks, you may receive periodic payments from the company if it makes a profit. These payments are called dividends and you’ll usually have to pay tax on them (there are some exceptions to this, which we’ll explain later).
Dividends are classed as either qualified or non-qualified depending on how long you’ve had them for. The tax you pay on non-qualified dividends depends on your income tax bracket. The tax you pay on qualified dividends is 0%, 15% or 20%, depending on your taxable income. Higher and additional rate taxpayers will pay more taxes on both types of dividends.
Capital Gains Tax
If you sell your investments and the profit you make from them is more than £12,300, you have to pay tax on the profit that’s over that amount. Again, you’ll be taxed on it at the same rate as your income.
It’s also worth mentioning capital loss here. If you sell your shares for less than what you bought them for, you could declare a reduction in income and therefore reduce your income tax bill. You could also carry the loss over to the following tax year and offset any capital gains you might make then.
Capital gains are taxed at different rates, depending on how long you’ve had the investment for:
Short term investment
This is an investment that you’ve had for less than one year and is taxed according to your income tax bracket, up to 37%.
Long term investment
This is an investment you’ve had for more than one year and is taxed at 0%, 15% or 20%, depending on what income tax bracket you’re in. These rates are usually lower than those on short term capital gains.
You don’t pay Capital Gains Tax if you give or sell your shares to your spouse or civil partner.
Stamp duty
This is a tax you pay when you buy shares. The amount you’re charged is based on how much you pay for your share and the way in which you pay for it.
You’ll be charged 0.5% tax when you use a stock transfer form to buy stocks and shares that are worth more than £1,000. The amount you pay will be rounded up to the nearest £5.
When you buy stocks online, Stamp Duty Reserve Tax is automatically taken at the same time.
Tax allowances on investments
Personal allowance
Everyone in the UK gets a personal allowance. This means most people don’t start paying income tax on the money they earn until it exceeds £12,570.
Your allowance could be bigger if you claim for things like marriage allowance or blind person’s allowance, but it could be smaller if you earn more than £100,000 per year.
If your only income is from investments and you don’t exceed £12,570, then you won’t have to pay tax on it.
Personal savings allowance
In addition to this, everyone gets a personal savings allowance. It allows you to earn interest on your savings without paying any tax on the interest.
The allowance you get depends on your income tax band. Basic rate (20%) taxpayers can earn £1,000 and higher rate (40%) taxpayers can earn £500 in savings interest per year before they have to start paying tax on it. Additional rate (45%) taxpayers don’t get an allowance.
While this allowance doesn’t cover dividend payments from shares or funds (there’s a different allowance for that – see below), it does include interest distributions from open-ended investment companies and investment trusts.
Dividend allowance
The dividend allowance for the tax year 2021/22 is £2,000 a year.
The tax you pay on dividend payments over this amount again depends on what income tax band you’re in. Basic rate taxpayers pay 7.5%, higher rate taxpayers pay 32.5% and additional rate taxpayers pay 38.1%.
If you’re a basic rate taxpayer and you receive dividends of more than £2,000, you’ll need to complete a Self Assessment tax return.
Stocks and shares ISA
You can put up to £20,000 a year into a stocks and shares ISA. This means any dividend income that’s paid into it will be tax-free, regardless of the dividend allowance.
If the value of your investment increases in your stocks and shares ISA, you don’t need to pay Capital Gains Tax on the profit you make either.
How to keep even more of your money
If you’ve decided that investing is the way to go but you’re worried about the tax implications this could have on your finances, you might find the following tips helpful:
Hold onto your shares long enough for them to count as qualified. That way, you could pay less tax on your dividends.
Hold on to your shares for a year or more so you get the long term capital gains tax rate when you sell.
Keep your shares in a tax-free investment account like an IRA or 401(k).
If you’re a business owner, accounting solution Ember can help you with your taxes. Unlike other accounting software, it’s run by real, certified accountants who are always on hand to offer tax-optimising advice.
While it’s exciting to watch your investments grow, you should bear in mind that your tax bill might do too, so you need to be prepared for this. Remember that even if you’re not selling your stocks for a profit just yet, your income tax bracket may go up because of dividend payments. If you can, try to set some money aside so you’re less likely to be caught short at the end of the tax year.
