Convert Income to Capital Gain and Pay Less Tax

by Richard Slater - Date: 2007-02-04 - Word Count: 529 Share This!

Most people distinguish between capital and income. You read about people, especially retired people, whose capital sits in a bank or building society account while the owner lives on the income alone (mustn't touch the capital!). For people with little money and financial knowledge this is not a bad rule, except of course the capital depreciates every year due to inflation. I learnt many years ago that you should regard your money as a machine that generates cash. At times the machine may grow bigger or smaller, but as long as it continues to generate the cash, that is OK. The cash may be income, interest, dividends or capital gains - it doesn't matter. It's still money in your bank account. And in the short-to-medium term, as long as you don't need to touch your capital, it doesn't matter if it shrinks. (Actually you gain a little bit - investment fund managers take a fee each year that is usually calculated as a percentage (1% - 1.5%) of the fund value, so whenever the fund shrinks, their fee falls).

This all assumes you have a cash reserve of readily accessible 'rainy day' money (in a high interest account, not a high street bank, please!).

In the UK, when you retire, you have to draw your pension (state as well as personal and/or company pension) as taxable income, and this uses up your personal allowance and your low rate tax band: any additional income is then taxed at 22% (and then 40% if you have a very good income!).

However, if the funds that generated this additional income are invested in a way that will produce capital gains instead, these gains are tax-free (up to about 8,000 per tax year, an amount that is usually indexed annually in the Budget). Capital losses can be carried forward for up to six years and offset against subsequent gains.

This rule applies to everybody, but this example (roughly; figures have been rounded for simplicity) applies to people aged 65+ and shows how this can work. In each case, the person is assumed to have an annual income of 20,000.

Case 1. Total income: 20,000, all from pensions, interest and dividends.

Tax on the first 7,500 (personal allowance) 0

Tax on the next 2,500 (lower rate 10%) 250

Tax on the last 10,000 (standard rate 22%) 2,200

Total tax paid: 2,450.

Case 2. Total income: 20,000, of which 15,000 is income from pensions, interest, etc. and the other 5,000 arises from capital gains.

Tax on the first 7,500 (personal allowance) 0

Tax on the next 2,500 (lower rate 10%) 250

Tax on the last 5,000 (standard rate 22%) 1,100

Tax on the 5,000 capital gain 0

Total tax paid: 1,350.

All you have done is exchange 5,000 of income for 5,000 of capital gain, and you've saved about 1,100 in tax.

Case 3. If you can get the income down to 12,000 and the capital gain up to 8,000, you will do even better:

Tax on the first 7,500 (personal allowance) 0

Tax on the next 2,500 (lower rate 10%) 250

Tax on the last 2,000 (standard rate 22%) 440

Tax on the 8,000 capital gain 0

So the tax paid drops again to 690, saving about 1,750 compared to Case 1. And remember, you can do this every tax year!

Related Tags: personal finance, taxation, pensions, capital gains, retirement income

An English science graduate, I learned modern, everyday business Swedish 'on the job' while living and working in Sweden for 11 years. I offer translation from Swedish to 'British' or internation al English as well as English copywriting from Swedish source material. My education and experience means that high-tech subjects are not a problem.

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