What a busy few years it has been with all the tax changes coming in. For a lot of limited company directors/contractors what it has meant is more taxes to pay. Changes to the way dividends are taxed has left a lot of owners wondering what they can, or indeed should, do with their earnings.
How dividend tax regulations have changed
As many company owners are all too aware, dividends are no longer tax-free up to the higher rate threshold, as HMRC have removed the 10% tax credit. Now everyone receives a £2,500 tax free dividend allowance with the remainder being taxed at 7.5% for basic rate tax payers, 32% for higher rate tax payers and 38.1% for additional rate tax payers, which is slowly putting you more on par with a PAYE earner.
For anyone who has their partner on as a shareholder, it does open up the dividend allowance to them, but what other options do you have? Most of the clients I speak to are restricting their drawings to £45,000 per annum to stay within the basic rate band. Their remaining earnings are left as retained profit within their limited companies and are generally held in cash.
What to do with your short-term cash as inflation ticks up
Short-term cash was not always a bad asset class to hold. Over the last few years, especially when inflation was 0%, or even negative, having large cash reserves wasn’t a problem at all. However, with inflation in the UK creeping up now and sitting at 2.5%, holding excess cash is not looking like a smart move.
There is a major caveat to my last statement: You should always hold sufficient cash within your company that can cover at least 6-12 months expenses depending on your cashflow needs.
But once your company’s short-term cash requirement is achieved, what do you do with the rest? Put it in a notice account to earn less than 2%? In this situation, you are already guaranteeing a loss with inflation at its current level, which is clearly not optimal.
Surprisingly, when we first meet our clients many of them think this is the only option and end up building up a rather high cash position in their company. There are, however, a number of options you can look at, such as:
- Funding a personal pension
- Investing the funds in the stock market
- Buying a buy-to-let investment property
Comparing your investment options
How do these three investment options compare? I’ve created an example using an initial lump sum of £100,000 and over a time period of five, 10 and 15 years. Let’s take a look:
In the table below, I’ve had to make some assumptions about growth rates. We’ve assumed anaemic growth rates on property prices in London and South East properties are hitting an affordability ceiling and foreign inflows are being hampered by tax changes. So, we’ve assumed inflation growth only.
For other asset classes (equity and bonds) we’ve used Thomas Piketty’s 300-year long data series on asset class returns. Piketty’s data estimates a long run average gross return on equities of 7% and 4% for bonds. His long run total return for property is 5%, which includes income yield and capital growth (Piketty, Thomas. ‘Capital in the 21st Century’ Harvard University Press, March 2014).
Initial Amount invested: £100,000
|Annual net growth rate||4.00%||4.00%||4.50%|
|Average returns||Includes tax relief|
|5 years||£ 41,665.29||£ 21,665.29||£ 24,618.19|
|10 years||£ 68,024.43||£ 48,024.43||£ 55,296.94|
|15 years||£ 100,094.35||£ 80,094.35||£ 93,528.24|
*A General Investment Account allows you to hold investments outside of tax wrappers. such as pensions or ISAs.
Property purchase at £400,000
(£100,000 used as deposit, £300,000 loan amount)
|Annual net growth rate||2.90%|
|Income received||4% yield|
|Monthly Net Rental||£1,173.04|
|Annual Net Rental income||£14,076.48|
|Annual Property Costs||£14,200.00|
|Tax relief||Up to mortgage interest cost|
|Average returns||Property growth||Income received||Total return|
|5 years||£61,463||-£ 617.60||£60,845.40|
|10 years||£132,370||-£ 1,235.20||£131,134.80|
|15 years||£214,173||-£ 1,852.80||£212,320.20|
*Net monthly rental adjusted for agents fee's
* We have factored in £2,200 per annum for property costs
What we can infer from this example
As you can see the returns can vary widely, if we look at a five-year period a company GIA would have returned from £21,665 while property would have returned up to £60,845. These are your gross returns though and the initial purchasing costs should be taken into account to give you a net-growth position.
Each option above has its own pros and cons, which is where a financial adviser can come in and help you explore each option to see which is the most appropriate investment solution for you. Let’s explore each one individually.
Another option for anyone that is interested in property and wants to build up a portfolio is to start purchasing property within a limited company. You cannot use the same company you work out of and will need to set one up with the sole purpose of investing in residential property (including buy-to-lets).
You can fund the new buy-to-let with your retained income from your company. This will, in future, create a great opportunity for you as you’ll be able to extract any rental profits, up-to the value of the loan, tax-efficiently.
Buying property in a company structure is more expensive, has few lender options and can be tax inefficient if you are required to sell a property to release the capital to yourself. Don’t forget that property is an illiquid asset and it may be difficult to sell.
With careful planning, however, the limited company structure you use can offer future tax-planning opportunities, can currently offset all the mortgage interest against the rental income and can keep all property investments in one easy to reference place.
A pension is the most tax-efficient way to save. Any contribution is made gross and incurs no personal taxes, and you get corporate tax relief on that contribution. However, the funds are locked away until you are at least 55, so paying in too much could leave you with a cash flow problem. You are also restricted with regards to how much can be paid into a pension in each financial year.
Currently the annual pension allowance is £40,000. In certain instances, we can use carry forward where available. I won’t go into too much detail on that one right now but feel free to email me with any queries you have.
Investing in the stock market
Investing your limited company funds in the stock market is a great way to earn a return. There are a number of different ways you can do this, depending on your preference. You can invest in a general investment account (GIA) which gives you great flexibility and fund choice. You can build a portfolio that is suitable to your risk level, but any investment has market risk which could mean that you end up with less than you put in.
Any funds invested in these ways are fairly liquid, giving you access when needed. It is therefore very important to make sure the investments chosen are right for you and your investment timeline.
You can also invest in a bond which has less flexibility, as you usually have to fund these with lump sums instead of regular investments. They can be a clean wrapper as tax is paid inside but it can get messy if the disinvestment is done in a non-tax-efficient manner.
You will see in the table above that for the majority of buy-to-let purchases, cash flow is actually negative while the loan-to-value (LTV) is high. “In this example, we have used a 75% LTV (£300,000 loan divided into the overall property value of £400,000). Costs weigh-in heavily for property and if you are purchasing old properties, you tend to have higher maintenance costs. When purchasing a new building, you tend to have higher service charges. These costs effectively net themselves off in the long run.
How to choose the right investment
Is there a right mix of the above that would work for everyone? Since each option has its own place, figuring out which investment will work will depend on each person’s personal circumstances. Some people like to do a mix of all four, others will focus on pension and investments, while some view property as the only asset class to invest in.
With the help of a financial adviser, you can make sure that any investment decision made is the right one for you and is implemented in the most tax-efficient and cost-effective way possible.
Anyone sitting on excess cash should not think that there are no options available or that the interest that can be earned is too little to even bother with. The sooner your funds can be invested, the sooner you will benefit from the magic of compound interest. In the UK, we are lucky to benefit from a wide and sophisticated investment market with a plethora of investment opportunities to choose from.
I would recommend that you speak to your financial adviser to discuss the options above in more detail. If you have not worked with one before, we have a team of advisers that would be happy to help, so please do get in touch.
Give our team a call on +44 (0) 20 7759 7519 or send an email to firstname.lastname@example.org and we’ll gladly set you up with a consultation.
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