Do you need to obtain income from your investments? If so, there are many ways to do this. Some are more tax efficient than others.
Some investments produce a true income and others simply make withdrawals of your capital. One is not better than the other. It all depends on the level of income you require, your tax situation and your attitude to risk.
This section will look at some of the most popular ways of obtaining an income from your investments.
Income from cash accounts
There are periods when income from cash accounts of various types is the solution that many people are most happy with. What is there not to like about security of capital and a decent income to supplement your pension income for example? Unfortunately this is not one of those periods unless you are so rich that you can live on an income before tax of around 0.5%.
At the time of writing, according to moneysupermarket.com the best interest rate you can achieve for tying your money up for five years is 1.1% pa. That’s a gross income before tax of £1,100 a year on a £100,000 deposit. According to the Office for National Statistics inflation as measured by the Consumer Prices Index was 0.7% for the 12 months to October 2020. Even if inflation does not rise in the next five years, which I think is very unlikely (see Understanding inflation as the biggest risk to financial health for older/lower risk investors), your £100,000 will end up with the purchasing power of £96,549 at the end of the five years thus undermining a large part of the income you have received.
Annual interest above £1,000 is taxable for basic rate tax payers; annual interest above £500 is taxable for higher rate tax payers; and all interest is taxable for additional rate tax payers. The interest from Cash ISAs is not taxable but with interest rates so low the tax saving is hardly important.
Income from peer-to-peer lenders
If you deposit money with a bank you are effectively lending them your money. The bank then lends your money to its borrowers, possibly to buy a property or fund a business. Peer-to-peer lenders match lenders with borrowers in the same way as a bank and are also regulated by the Financial Conduct Authority. The difference is that no bank is involved and the FSCS protection of up to £85,000 per account does not apply.
Lending money via a peer-to-peer lender is therefore an investment rather than a savings account. There is a noticeable risk to your capital. As a result of this the Financial Conduct Authority has announced that with effect from 9 December 2020, firms won’t be allowed to let those who haven’t had independent financial advice put more than 10% of their investable assets (i.e. excluding your home and pensions) into peer-to-peer.
For those who can afford to take the risk (i.e. the loss of their investment would not affect their standard of living) interest rates can be a lot higher than those for cash accounts. Rates currently range from 3%-4% where your money is loaned in relatively small amounts to a number of borrowers and therefore relatively less risky. At the other end of the risk scale rates of around 9% are available where you are lending to one large borrower often on a more speculative building project.
Annual interest is taxable in the same way as interest from a savings account. The interest can be sheltered from tax by using an Innovative Finance ISA.
Interest from government securities
Loans to the UK Government, referred to as Gilts (i.e. originally debt securities that had a gilt (or guilded) edge), have always been a popular way of investing for the purposes of receiving an income. Those with larger amounts to invest have simply purchased suitable gilts directly and those with smaller amounts have purchased gilts through a gilt fund or through products offered by National Savings & Investments.
As with cash, this is not a good time to be relying on gilts for your income. At the time of writing a 10 year gilt returns around 0.315% pa.
If you believe that inflation is going to come back much stronger over the next decade then you might want to use an index-linked gilt. For example the Treasury 0.125% Index-Linked 2029 will provide annual interest of 0.125% in excess of inflation over the next eight years. However, you will currently have to pay around £128 for every £100 of this index-linked gilt that you purchase so you will suffer a 22% loss of capital over the period.
Annual interest and accrued interest is taxable on gilts but there is no tax on any capital gain.
Gold as an investment
Gold is useful as part of your investment portfolio in a similar way that government and corporate bonds are. That is, it provides protection from equity markets when they are falling. Unlike government and corporate bonds, however, gold is not able to provide any form of income. Furthermore gold is a very volatile asset which tends to behave illogically at times.
Gold is of no use to you directly in terms of income. However, there will be times of real uncertainty such as now, when holding a small percentage of your wealth in gold or gold funds will allow you to invest for income in equities whilst at the same time reducing the potential size of any loss on your overall portfolio.
When people consider dividend income they often think of owning a small number of UK shares. This comes with all the risk to their capital as well as the hassle of including numerous dividend payments on their tax return. The solution is to use some form of collective investment instead. This might be a single equity income fund of which there are over 70 UK Equity Income funds producing a yield of at least 3.5% and as high as 8.0%.
With Brexit looming, investing just in the UK is not a great idea, if ever it was. There are 13 Global Equity Income funds producing a yield of at least 3.5% and as high as 9.0%.
Of course, the advantage of getting your income from dividends is the prospect of capital appreciation over the long term in addition to the income. Another way to look at it is that any capital appreciation will provide the potential of an increasing income to combat the effects of inflation.
A relatively lower risk solution is to use some form of multi-manager equity income fund or a risk-rated equity income portfolio. Both of these benefit from administrative simplicity compared to owning a number of direct shareholdings.
Equity Income funds can, of course, be sheltered from tax in a Stocks and Shares ISA Account so that tax free income can be provided. This is especially beneficial if you are a higher rate tax payer.
Dividend income from venture capital trusts (VCTs)
Venture Capital Trusts are a high risk investment and not suitable unless you have both a more adventurous attitude to risk combined with a high capacity for loss. In other words the total loss of your VCT investment would be insignificant enough so as not to affect your standard of living.
As the underlying investments in a Venture Capital Trust are unlisted companies, or are at best only listed on the Alternative Investment Market (AiM), they are much higher risk than unit trusts or OEICs.
If you are prepared to take the risk, however, and invest sensibly, they are a good way to produce tax free income. I have been building a portfolio of VCTs for 14 years now, just investing between £3,000 and £10,000 in most tax years. In the 2019/2020 tax year my portfolio produced a tax free dividend income of just over 7.0% of my total net investment, much of which I reinvested as I don’t need the income at present.
Regular withdrawals from unit trusts and OEICs
A common mistake by investors is to restrict their search for income to income producing investments. As a result of the generous annual exempt amount for capital gains tax which is currently £12,300, a tax free ‘income’ can be withdrawn from many investments. For example, if you were to invest in a low risk well diversified portfolio it would not be unreasonable to expect it to produce at least 3% a year net of charges on average over the next five to ten years. If you arranged to withdraw 3% a year to be paid monthly into your bank this would be free of tax if within the annual exempt amount.
So let us say that you were able to invest £500,000 into a portfolio of unit trusts or OEICs. Assuming you were not making capital gains elsewhere you could withdraw a monthly tax free ‘income’ of £1,375 (i.e. 3.0%) which would be covered by your annual exempt amount. Bear in mind that only part of each withdrawal would represent a potential chargeable gain. Naturally if this were your only investment you would want to transfer £20,000 a year into a Stocks and Shares ISA to enable a higher income to be taken without fear of being taxed when circumstances allowed.
Regular withdrawals from investment bonds
The special tax treatment of investment bonds can be valuable if you already make full use of your annual capital gains tax exempt amount.
HMRC has agreed that as far as the bondholder is concerned, tax equivalent to the current basic rate of income tax in any year (20% for 2020/2021) is deemed to have been deducted at source. Five per cent of the original investment in such a bond can be taken as ‘income’ each year with the tax deferred until the bond is surrendered. If the surrender takes place when that person is not a higher or additional rate tax payer then no additional tax is likely to be required on that ‘income’.
So if you invest £100,000 into an investment bond you can withdraw £416.66 a month for up to 20 years without having to account for any tax on that ‘income’ during this time.
If you are not keen on the idea of withdrawing capital and can cope with a lower level of income you could opt for a distribution bond. In this case the income you receive is a true distribution of the actual income produced by the underlying investments. However, the income is still treated as a withdrawal for income tax purposes and will be tax deferred for up to 20 years provided that the income remains within 5% pa on a cumulative basis.
One issue with investment bonds is that a non tax payer cannot reclaim the tax deducted at source. If this was likely to be a problem then you could use an offshore investment bond where no tax is deducted at source. Withdrawals of up to 5% pa can still be taken on a tax deferred basis but a basic rate tax payer will be liable for tax on the gain when the bond is finally surrendered.
Interest from a structured product
In simple terms, structured products are a type of tracker fund, linked to a stock market index such as the FTSE 100. However, under the bonnet they are far from simple, and they can be markedly complex financial tools. Structured products have been defined as ‘products that deliver a known return for given product circumstances.’
There are many types of structured products which are available to retail investors but there are two that are particularly useful for those seeking income:
Structured deposits – these are the lowest risk structured products as they are always capital protected at maturity and invest in cash deposits, with the interest payments linked to the performance of an underlying asset, often the FTSE 100. If held to maturity, even if the underlying asset has fallen in value, you will receive back the initial amount invested in full.
Most importantly, structured deposits that are registered in the UK are covered by the Financial Services Compensation Scheme (FSCS) up to the statutory limits, ie £85,000 for a single depositor per authorised institution.
At the time of writing one of the products available aims to generate monthly income payments of 0.12% gross (i.e. £120 pm for an investment of £100,000), which are dependent upon the performance of the FTSE 100 Index throughout the six year investment term. The pre-defined income payments will be paid each month provided that the FTSE 100 Index does not close 25% or more below the Initial Index Level (subject to five day averaging). If the Index closes at or below 75% of the Initial Index Level (subject to five day averaging), income will not be paid for that period. As a deposit, this plan is designed to return investors’ original capital in full at maturity, regardless of the movement in the Index during the investment term.
Capital at risk products – these are high risk products and only suitable for investors who can afford to risk their capital.
At the time of writing one of the products available aims to generate gross quarterly income payments of 0.75%, which are dependent upon the performance of the FTSE Custom 100 Synthetic 3.5% Fixed Dividend Index throughout a maximum ten year investment term. Income will be paid provided that on each of the quarterly observation dates, the Index closes at a level no more than 30% below its Initial Index Level. If on any quarterly observation date the Index does close more than 30% below its initial level, no income payment will be made in respect of that period.
The plan will terminate early from year three onwards if on any quarterly observation date the Index closes at least 5% above its Initial Index Level, in which case investors’ original capital will be returned in full in addition to a 1% gain for each quarter the plan has been in force, plus the income payment due for that period. If the plan fails to mature early and the Final Index Level is more than 30% below its Initial Index Level, then investors will suffer a reduction to their invested capital of 1% for every 1% the Final Index Level is below the Initial Index Level.
Income from property
It seems that the dream of large numbers of people is to own a second property in addition to their main residence. Owning a buy-to-let has been very popular for many years and is encouraged by a number of television programmes showing people purchasing a run down property and turning it into a very nice house which they then rent out.
Very rich people have usually turned to owning land and property as a reliable source of income. The danger, which I have seen on many occasions throughout my career, is that those with more limited means sink all of their available capital together with further borrowing into a single additional property.
In some areas of the country (typically in the North of England and Scotland) the rental yield can be as high as 8%, while other areas are around the 3% mark. Of course there is the real potential for capital growth.
The problem with buy-to-let is when it is held as the only or main investment. The property you purchase is an illiquid investment as it can take months or even longer to sell if you need the cash. Of course, you cannot sell a small part of the property if you suddenly need, say, £20,000. The tax on both the income and capital growth is more onerous than on many other forms of investment which reduces the real income you are obtaining.
Having been a landlord of commercial offices during my career I can assure you that it is a big responsibility and not to be undertaken lightly even with professional help. Having a portfolio of investments from which you can withdraw money as and when needed has a greater appeal.
Links to more information
- Focus on ISAs (Individual Savings Accounts)
- Focus on Unit Trusts and OEICs
- Focus on Investment Trusts
- Focus on Investment Bonds
- Focus on Structured Products
- Focus on VCTs (Venture Capital Trusts)
- Money Advice Service notes on Saving and Investing
- If you need personal financial advice on Arranging Income from Investments then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.