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Some investors may have never bothered to use their ISA allowance. The current Capital Gains Tax allowance of £12,300 may have seemed generous enough to cover any gains, while a tax-free dividend amount of £2,000 may have covered most of the portfolio income. But, unfortunately, this relatively generous allowance is coming to an end, as the following table shows:
There is also the risk that these allowances never get raised in line with inflation, further reducing allowances via stealth taxation.
An investor that has filled their ISA every year for five years and generated some reasonable returns could easily have £150k in their ISA by now. But what happens to the ISA investor over the next 25 years versus an investor who had the same amount in a General Investment Account (GIA)?
To model this, I need to make a couple of assumptions: the investment returns, what proportion of those returns come from dividends, and how often an investor may turn over their portfolio. To start with, I assume the long-term market averages, which is approximately 9% nominal return, half of which comes in the form of dividends. For the Turnover Ratio, academics Barber and Odean found that the typical individual investor turns over 75% of their portfolio yearly. Of course, an investor turning over 75% of their portfolio annually may have much higher fees than an index tracker. However, since I am interested in the comparative performance here, I will ignore the impact of fees on performance since these will be similar for an ISA or a GIA.
Starting with the £150k on 1st January 2023, I assume that over the next year, the portfolio generates £6,750 of capital gains, of which 75% or £5,063 is realised, and £6,750 of dividends. Since this gain occurs in Tax Year 2023/24, there is no capital gains tax to pay. But £5,750 of the dividends are taxable. The net amount after taxes, I assume, is reinvested back into stocks, giving a portfolio value of for the basic Rate Taxpayer of £162,997 and £161,599 for the Higher Rate Taxpayer. This is compared to the ISA investor, who has kept all the gains and has a £163,500 portfolio after reinvesting their dividends. (Again, I am ignoring costs since this will be similar for both types of accounts.)
These differences seem slight at this point. However, the impact becomes clear when I repeat the calculation for the next 24 years with the lower 2024/25 Tax-Free Allowances. The following chart shows the returns of this portfolio over the next 25 years in an ISA or a GIA for both a Basic Rate and Higher Rate Taxpayer:
As well as demonstrating the power of compounding investment returns (a £150k starting investment has become almost £1.3m in this period), the impact of taxes is very apparent. Under the currently announced tax regime, the Basic Rate Taxpayer has a portfolio that is worth £84k less, while the Higher Rate Taxpayer has lost a whopping £259k to the taxman:
As this chart of US stock market returns from macrotrends shows, the return profile of the stock market is anything but the consistent 9% growth I have assumed:
It is difficult to model this since no one knows the future path the stock market returns will take. However, if anything, the more volatile likely outcome means the loss to taxes will be higher than modelled. This is because there will be years where there may be no capital gains to utilise the full tax-free allowance. Similarly, there will also be times when realised capital gains are significantly above the tax-free allowance. Therefore, the actual performance of the taxed portfolio may be worse than I have modelled.
The Value investor isn’t just seeking market returns. They are seeking to beat the market by bearing greater risk, including potentially higher volatility, and taking advantage of the behavioural biases of other investors. A simple quant strategy of buying the cheapest stocks has historically led to strong outperformance, as this table from Gray & Carlisle, based on 1971-2011 US data, shows:
So what happens if I take the annual return of the best-performing strategy, Enterprise Multiple (EBIT Variation), which is Earnings Yield under the Stockopedia definition?
(Since this is a quant strategy, the assumption is that the portfolio is reformed every year, making the Turnover Ratio 100%.)
The higher returns show why it is worth the effort to develop the skill and strategy that gives investors the best chance of outperforming the market and utilising all the available Stockopedia tools to help investors achieve this aim. After 25 years, the higher-performing investor has turned £150k in £4.5m!
The impact of taxes is equally stark:
A Basic Rate Taxpayer who failed to utilise their ISA allowance has a portfolio worth almost £400k less. Even worse, a Higher Rate Taxpayer is over £1m poorer due to their failure to use available tax shelters.
Of course, these figures are nominal, and £1.1m won’t buy what it does today in 2047. However, if we assume 3% average annual inflation, the real cost to a Higher Rate Taxpayer is still over £500k in today’s money. Enough for a couple of Lambos!
Or, for the more altruistic, a very sizable charity donation.
The first thing such an investor can do is to maximise their existing ISA allowances. However, the modelling reveals a couple of quirks of the current tax code that an investor may be able to use to optimise their post-tax returns:
When I looked at the reasons behind the performance of value investments, I included the following chart from a study called Factors from Scratch:
This chart shows the average Earnings Per Share (EPS) and Price-Earnings Multiple progression of a Value portfolio formed from quantitative data from the point of formation. It demonstrates that value stock portfolios outperform because they tend to see multiple expansion. This occurs even as the EPS declines, as the market anticipates the eventual stabilisation and recovery in business performance. This multiple expansion is most rapid in the first year but continues for around four years and is typically joined by growing EPS. This means that a value investor can choose to be relatively slow to re-balance their portfolio. Holding periods of up to 4 years should see continued outperformance. If I reduce the Turnover Ratio to 25% to represent this slower re-balancing, then the Tax losses are significantly lower:
The tax impact is particularly harsh on income investors using a GIA due to the lower tax-free allowances on dividends:
A Higher Rate Taxpayer who earned the 9% market return but chose high-yielding stocks so that 80% of their returns came from dividends would see a further £64k lost to tax over the 25-year period:
However, if they chose to focus on low-yielding stocks, with just 20% of the returns from dividends, they would gain a further £65k.
A Higher Rate Tax paying value investor generating a 14.55% annual return can still turn £150k into almost £4m over 25 years, as long as they invest in low-yielding value stocks and turn their portfolio over very infrequently:
However, the moral is: it is best to have as much of the portfolio in ISAs as possible.
Disclaimer: All returns discussed here are theoretical and exclude the impact of trading costs. Future returns may vary significantly from historical returns.
About Mark Simpson
Value Investor
Author of Excellent Investing: How to Build a Winning Portfolio. A practical guide for investors who are looking to elevate their investment performance to the next level. Learn how to play to your strengths, overcome your weaknesses and build an optimal portfolio.
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It will be nice to get back to making some decent capital gains! I have plenty of losses to offset against future gains. Although I am still trying to get as much into the ISA as possible before year end.
Any ideas what happens if I sell a share not in an ISA at a loss, buy it back in the ISA and later sell it for a profit? Can I still use that loss to offset against other non ISA gains? I am a bit of an ISA rookie, but realising I need to make maximum use going forwards.
Any capital gain or loss is crystallised only at the point of sale. So you make a loss. The value is entered into your ISA. From that point, ANY gains or losses are disregarded, and you don't even report your ISA. BUT, ISA losses cannot be used to offset gains elsewhere. Just think of your holdings as going into a black box. Remember also that dividends are tax-free and not reported.
AND, they haven't changed the Flexible ISA. If you set it up as that, you can extract as much as you like, and you can put it back in during the year, useful if, like me, you take income from ISA divs now but find you have some spare at the end of the year. I will put a bit back in in the next two weeks, to refill. After April 5th your annual allowance is gone. Nothing can be backdated.
Hope this helps.
Yes you can offset gains by losses, outside your ISA, it is the total gain, ie profits minus losses = gain for CGT. So if you have made £15,000 profit from sales, you can then sell loss making shares to reduce your gains to below your CGT allowance. You can deduct costs, such as buying and selling fees also.
ISA you don't need to declare anything.
I would look to get the highest dividend shares within your ISA.
Thanks for your replies. Really useful. The dividend allowance changing was the key driver for starting to make better use of the ISA.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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This makes for grim reading Mark but well done. My take is that the government wants people to spend all they earn, as it is earned, the shortest cut to communism as you can get. Of course, there need be no change in the pecking order, no need for opposition parties in politics either since they are all in it together. Glad that I am well into my fourth quarter and here's luck to the rest when the ISA is laid to rest.