In the second part of a new series of articles aimed at beginner investors, self-confessed finance nerd Prerna Khemlani, founder of This Girl Invests, explains why it is more important than ever to understand tax and its impact on every aspect of our finances.
The impact of the change in national insurances has been a topic of much debate. It has brought to the surface the importance of understanding taxes. I remember the first time I thought ‘Understanding taxes is not boring – it’s life changing!’ – I was reading Money by Yuval Noah Horari (Yes! THE Yuval Noah Harari of Sapiens! Yes, he does have a book ALL about money!).
He explained how we evolved from a society that exchanged items of value to a society that trusted paper as a form of ‘monetary value’. It was then when I was studying for my chartered accountancy that I learned the role taxes play in society, and the power of understanding the detail of taxes for a solid financial plan. This cemented my understanding. So why do taxes exist?
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Taxes are a big source of income for governments, which can then be used elsewhere in society, where the money is needed. Governments tax us on activities they would prefer we did not pursue (drinking alcohol, smoking, gambling, etc.) and give us tax breaks (aka allowances) for activities they would prefer we did (for example, pre-tax saving for retirement in pensions). This ‘nudge’ that taxes provide is designed to save the government from having to take care of us when we are older by minimising the chances we’ll end up with serious diseases or in poverty at retirement age.
But there are so many types of taxes. Where do you start to gain a better grasp? I’d start by understanding the different types of taxes and their purpose:
- Income tax - this is tax paid on your non-savings (e.g. salary or trading income), interest and dividend income.
- National Insurance (NI) - this is tax paid to the government, which counts towards your state pension. You need to have paid a certain amount to qualify for the full state pension.
- Capital gains tax (CGT) - this tax is paid when you sell an asset that has appreciated in value (‘gain’)
- Stamp duty land tax (SDLT) - this is tax paid when you buy a property
- Corporation tax - this tax is paid on company profits (not income!)
The key thing to factor in, though, is that you do not pay tax on ALL income but only income above a THRESHOLD known as the ‘allowance’.
Key allowances you should be aware of include:
- Personal allowance - you can earn £12,570* in overall income and pay no tax
- Trading income allowance - you can earn £1,000* in trading income each tax year and pay no tax
- Savings allowance - you can earn £1,000* in bank interest each tax year and pay no tax
- Dividend allowance - you can earn £2,000* in dividends each tax year and pay no tax
- ISA allowance - you can put up to £20,000 in ISAs and pay NO income tax and NO capital gains tax!
(*This is for the year 2021-22 - to make things complicated, these figures don’t always stay the same each year. The chancellor reserves the right to update these allowances as part of this Budget statement. You can find all the latest tax information by clicking here)
So how is this exciting? Well, understanding your taxes is empowering and can help you feel much more confident in your financial plan. For starters, understanding that paying national insurance impacts your state pension, you might think twice when deciding whether to pay yourself a dividend or a salary from your business.
Next time you wonder if your side hustle will be liable to tax, you’ll know if it is under £1,000 per tax year, you’ll probably be fine!
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And finally, next time you get prompted to decide between a General Investment Account (GIA) or an Individual Savings Account (ISA) for your investments, you’ll know an ISA is more tax-efficient.
Next time you’re doing your taxes – remember it’s exciting, not boring!
Prerna Khemlani is the founder of This Girl Invests, which has been featured on Glamour UK and Cosmopolitan UK. This Girl Invests’ mission is to help reduce the gender investment gap by using education as a tool to empower women to invest and to feel #financiallyconfident.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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