Tax Free Investments (& Where to Find Them)

Isn’t it great when you make a good return on your investments?

Then, maybe when you go to cash them in, or maybe when you file your taxes at the end of the year, maybe even both…

The government slices off a nice, healthy chunk of your hard-earned savings to pay for all the luxuries and privileges of living in a civilised society.

The only thing as certain as death, according (probably) to Ben Franklin. Taxes.

So what if you want to enjoy all of the benefit of your investment returns, rather than sharing with big brother? Here dwells the myth of the tax-free investment.

Yes. A myth. Sorry.

I mean, there are lots of investments that will call themselves tax-free. There are yet more that will be called tax-free by a marketing department or government office. There are even some countries that will claim to be tax-free, but let’s go back to Mr Franklin for his comment on the matter:

“Two things are certain in life.”

The fact is, tax is always there, somewhere. Personally, I would rather be fully aware of how much I am being taxed up front and in the open, rather than have deductions or additional costs sprung on me at the last minute.

Many of you will be aware of the abject joy expressed by American visitors on their first trip to Europe when they make a purchase in a store or restaurant, only to find that the bill is exactly the price that was written down. Contrast this with the confusion expressed by every European on their first trip to the US when they find the cashier asking for the seemingly arbitrary amount of money more than the price they calculated from the menu. Tax on investments can often seem like the latter.

Capital gains tax (long-term and short-term), wealth tax (in all its guises), dividend tax, investment income tax, withholding tax and distributions tax can all make the concept of a tax-free investment sound all the more appealing, and a quick Google search throws up loads of options for investing your money ‘tax-free,’ so why is this financial advisor saying they don’t exist?

The distinction, as so often in the world of finance, is in the terminology. Our industry is famous for trying to make itself confusing for everyone outside our little circle, so when something claims to be tax free, it means one of four things:

1. Tax deferred

This is where you don’t pay the tax now, but you promise to pay it later.

2. Tax-deductible

This is where you can receive tax back that you have already paid or, more commonly, swap a tax bill that you have already paid for an equivalent payment in the future.

3. Tax-advantaged

This is more subtle, and often means that an investment might have been subject to several taxes and some of them do not apply (eg. capital gains will not apply to growth, but income tax will be applied in the future) or that the tax level on this investment is lower than other choices that you might have.

4. Sneaky-sneaky clever marketing

Many tax-free programs just hide the fact that your money is going into treasury coffers by some other route via infrastructure programs, obligatory fees, tolls or subscriptions or just higher costs in the structure that allow the issuer to pay the tax on your behalf.

Don’t take this the wrong way – all of these can be great and may offer a significant advantage over some non-tax-relieved equivalent, but they are not tax free, and you will always have to sacrifice something in exchange for the tax-efficiency. This brings us to what we like to call the GAS principle.

All investments force us to choose a balance between three qualities:

Growth

Access

Security

The rule of thumb is that if you have the maximum of two elements, you have the minimum of the third. Think of it like three coffee cups on the table, but only enough coffee to fill two of them, like the classic hotel breakfast. Tax efficiency gives us more growth, so we will have to sacrifice one of the others – normally access. If you place your money in a pension, you have tax-deferral but your investment is locked up until retirement.

Understanding the GAS balance of your investments is important for balancing your different timescales with tax considerations.

“What about alternative investments? Those are really tax free!” I hear the contrarians shout from their cellars full of vintage wines.

Well, yes, possibly, but even in the best case (case of wine, anybody, no?), you end up paying somewhere else, just like all the toll roads in countries that don’t have vehicle tax. If you store money in classic cars, art, wines etc. then you need to account for proper storage, maintenance and insurance just to preserve the value you have. Even then, if the government sees that you make a big profit by selling those assets in the future, there will certainly be tax to pay on your gains. Anything that attempts to fly under the radar (yes, that means you, crypto) will eventually be treated just the same as any other lump of money.

The simple fact is that chasing ‘tax-free’ is pointless when ‘tax-efficient’ is more realistic and more tailored to your situation.

A good chat with your financial advisor will help you understand what sort of tax-efficient structures can help you towards your goals and a good tax advisor or accountant can make sure you are not paying any more tax than you absolutely have to.