Convert Income to Capital Gain and Pay Less Tax

Most people distinguishing between capital and income. You read about people, especially retired people, whose capital amounts in a bank or building society account while the owner lives on the income alone (must not 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 learned many years ago that you should regard your money as a machine that generates cash. At times the machine may grow larger 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 does not matter. It's still money in your bank account. And in the short-to-medium term, as long as you do not need to touch your capital, it does not matter if it shrinks. (Actually you gain a little bit – investment fund managers take a fee each year that is typically 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 initially in the Budget). Capital losses can be transported forward for up to six years and offset against subsequent gains.

This rule applies to everyone, 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!

Source by Richard Slater

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