Having spent the past few months studying for my financial adviser exams, I’ve realised that a) there are a lot of tax rules b) most of us do not have a clue how, or why, we could take advantage of them and c) all the information is pretty generic.
So let me take you through the basics of capital gains tax and why you probably won’t hear it called a ‘half-price’ tax anywhere else.
A brief lesson in CGT basics
Capital Gains Tax is a tax that you pay when you make a ‘gain’ (we’ll call it a profit) on something you own.
Here’s a simple example to show what a capital gain is:
5 years ago, I bought a painting for £500.
I’ve just sold it for £1500. My ‘capital gain’ is my ‘profit’ i.e. the difference between £1500 and £500, which is £1000.
I might have to pay Capital Gains Tax on that £1000, but we’ll get to that shortly.
While Capital Gains Tax could be applied to many things you own, the most common thing is stocks and shares. Property comes second, but with a slightly different set of tax rules.
For the purposes of this article, and because I’m a big believer in investing in the stock market, I’ll mainly focus on stocks and shares as the thing we own that could be subject to capital gains tax.
When do I actually pay Capital Gains Tax?
To put it simply, when you make more than £6,000 of ‘capital gains’ in one tax year (6th April – 5th April the following year).
Everybody in the UK has a Capital Gains Allowance each tax year.
The CGT allowance for 2023/24 is £6,000. This allowance applies to anybody, whether they earn nothing or earn £1 million. More on that later.
So, let’s take a stocks and shares example.
10 years ago, I bought shares in a company for £1000.
I sell those shares today for £2000.
My gain is £1000 (you might have slightly less factoring in selling fees)
I don’t need to pay any capital gains tax on that £1000. And I can still make another £5,000 of capital gains in the same tax year without paying tax.
What happens if my capital gains are over £6,000?
This is where tax is now almost certainly due.
Firstly, let’s go back to a tax you’re probably more familiar with: income tax.
Most of us pay income at the ‘basic rate’ of 20%. If you’re fortunate enough to be a high earner, your income tax rate could be 40% or even 45%
So, for our example, we’re going to presume we’re a basic rate income taxpayer.
Remember the title of this article – the half-price tax?
When you compare CGT to income tax, that’s effectively what it is for the vast majority of us.
So, looking at our table, a basic rate taxpayer pays 20% income tax – tax on their earnings, and 10% capital gains tax – tax on gains on certain things they own and sell.
There is some correlation between your earnings and your capital gains, so let’s go through another example.
I’m employed and earn £30,000 a year. That means I pay 20% basic income tax.
I own some shares and sell them which gives me a gain of £15,000.
First of all, I can take £6,000 of that £15,000 and put it straight in my pocket. No tax is owed on that amount. The fact I earn £30,000 is irrelevant.
That leaves me with £9,000 to sort out.
This is where my income tax rate becomes relevant. We established that I’m a basic rate taxpayer on earnings of £30,000.
You can earn up to £50,270 this tax year (2023/24) before you start paying higher rate tax.
That means that as long as my capital gain, when added to my earnings of £30,000,
doesn’t go over £50,270, then my capital gains tax rate is also calculated as basic rate but at the lower rate of 10%.
£30,000 + £9,000 = £39,000. Well within the limit. So I would pay 10% CGT on £9,000 and the rest is mine to keep.
There can be instances when you’re at the top end of being a basic rate taxpayer and then adding a capital gain would push you into the 40% income tax band. This would then mean paying 20% capital gains tax. But that’s enough complexity for now.
How can I make the most of this cheaper tax?
I personally think Capital Gains Tax and Capital Gains in general are vastly underused.
As I said, everybody gets the CGT allowance, no matter what they earn.
Here’s an example to get you thinking:
I’m earning £30,000 and I get a new job paying £6,000 more. I will pay 20% tax on that £6,000 (plus national insurance!)
If you make a £6,000 capital gain instead, your income that year is exactly the same, but you’ll pay a lot less tax, which mean’s more in your pocket.
Now I’m not saying you shouldn’t take a pay rise and a better job. I’m just showing how by diversifying your income, you can use tax allowances and cheaper rates of tax to pay less tax overall.
How easy is it to make a capital gain?
As I mentioned, most people make capital gains on stocks and shares. But of course, you can also make losses too. Losses can even be used to offset gains, Think gains minus losses = net gain. Any CGT is calculated using your net gain.
Another reason I’m a fan of capital gains tax is because we should all be investing in stocks and shares to help secure our futures.
And if we’re investing properly – a mixture of different shares, for the long-term and keeping calm during temporary crashes – then our money invested in stocks and shares should be growing.
One thing to say about capital gains on stocks and shares is that you don’t pay any potential capital gains tax until you ‘realise’ the gain i.e. you sell your shares.
I’ll give my parents as a real-life example. They have a lot of money invested in the stock market. They’ve made gains in theory, but they’ve sold very little.
They both have their £6,000 CGT annual allowance. So, in theory, they could sell £12,000 worth of shares this tax year and it will be tax-free cash.
Of course, when investing in the stock market, the first places to start are by using your annual £20,000 ISA allowance, which means you’ll avoid CGT on gains made on that £20,000. And paying into a pension so you can get added tax relief.
If you’re fortunate enough to own valuable possessions, you potentially have an even easier time avoiding tax on gains.
For assets like artwork, jewellery, furniture, etc, proceeds (not the gain) must be over £6000 before capital gains tax is even considered.
So if you own a painting and sell it for £6000, that doesn’t even eat into your annual allowance.
Property ownership - specifically second homes - have a different set of rules and are subject to higher rates of tax if you make any gains over your annual allowance.
Think income diversity
Tax rates and allowances vary depending on the type of ‘income’ they relate to; wages, investments and physical assets are the 3 most common ways of getting income.
So by spreading your income over different types of tax, you effectively boost the amount of tax-free income you can make and could even reduce the amount of tax you pay had all of your income come from the same tax bucket.
