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Chris Exley DipFA
Creator of MoneyGeek | Financial Coach, Planner
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MoneyGeek Digest - Issue 15: 120% Capital Gains Tax Trap - The Problem With the Current System (and how to avoid it)
Dear Reader,
I hope you are all enjoying a sunny and relaxed bank holiday.
The topic of this weeks newsletter:
How can a £10,000 gain attract £12,000 in tax?
I was chatting to a friend over a beer last weekend - as often happens - the conversation pivoted to finance.
He invested a £100,000 conservatively back in 2016 within a GIA (a taxable investing account) - he's in the fortunate position that he can fund his ISAs out of income.
It's now worth £150,000 and he's upgrading the family home - so needs it out.
On paper — that's a £50,000 gain. He felt the 24% Capital Gains Tax liability was fair - £12,000 tax.
But then we factored in inflation.
Nine years at around 3.5% annual inflation means £150,000 today is worth roughly £140,000 in 2016 money.
His real gain - the actual increase in purchasing power - was closer to £10,000.
His tax bill? £12,000.
Effective rate on his real gain when you put it like this: 120%.
He didn't make money in any meaningful sense he's just about kept up with inflation.
And 100% of his real gain would be taxed.
THIS IS THE PROBLEM WITH CAPITAL GAINS TAX
Wes Streeting wants to raise Capital Gains Tax to match income tax — up to 45%.
He's half right - CGT is broken. But the debate is entirely about the rate, and missing the bigger issues - the fact we're being taxed on inflation.
Here's what I think actually needs to change.
Tax real gains — not nominal ones
Nigel Lawson got this right in 1988. He equalised CGT with income tax — but added indexation relief.
You were only taxed on gains above inflation. Gordon Brown scrapped it ten years later.
Restore that, and the 120% problem disappears.
Short-term speculative gains get taxed more heavily.
Long-term patient capital gets treated more leniently.
But the nuance here is that cash gains are treated as income (outside of allowances) as they are received - they don't form part of the Capital Gains Tax regime.
How to fix it (partly)
For those of us with cash in our non-tax advantaged General Investing or Share Dealing accounts - there are a few methods available to us to reduce this liability:
- Bed and ISA / Pension Transfers - Now gains will still be taxed, but you can reduce those gains by selling down and transferring into an ISA (Bed and ISA) or a Pension.
- Capital Gains Tax Allowance - £3,000 of gains can be realised each year without triggering a tax liability - though this is difficult. This allowance was over £12,000 at its highest in 2020. This could be through selling to realise that gain and reinvesting in a similar fund.
- Transfers Between Spouses - Transfers between spouses are treated on a no gain / no loss basis meaning assets can potentially be transferred to make use of their allowances too.
- Dividend and Interest allowances - for income producing investments - there is a small gain to be made on income - but realistically with a dividend allowance of just £500/yr - this is largely inconsequential and difficult to manage.
- Use your ISA allowances - even if you're not investing - Cash ISAs can help shelter cash in a CGT free environment. Because the allowance resets every year, the more you can get in early, the more flexibility you might have - though rules are changing around these soon.
If my friend had taken some of these actions - purely on making the most of CGT allowances - his gain would been wholly chipped away and the tax liability dramatically reduced.
As always - we're in a position where the investor must make take action on an annual basis to reduce their liability over time.
Enjoy the sun.
Until next week.
