It could be worth doing the sums (Image: MementoJpeg via Getty Images)
With income tax rates at their highest level in a generation, financial experts are encouraging higher-rate taxpayers to look beyond advertised interest rates and concentrate on what they genuinely retain after taxation.
According to wealth manager Paul Denley, numerous investors are neglecting one of the limited remaining tax-efficient options available outside an ISA or pension: low-coupon UK government bonds, known as gilts. He explained that while most individuals compared investments based on their published return, the tax treatment can prove even more significant.
Mr Denley, CEO at London-based Oakham Wealth Management, said: “It’s not just about what an investment earns. It’s about what you keep after tax.
“With tax allowances having been reduced over recent years, improving your after-tax return has become much harder. Low coupon gilts remain one of the few notable exceptions.”
‘Exempt from tax’
An expert has explained how it works (Image: Pexels)
Unlike interest generated on a conventional savings account, capital gains realised on UK government gilts are exempt from Capital Gains Tax. What renders low coupon gilts especially appealing is that they deliver comparatively modest interest annually, meaning a greater proportion of the total return derives from the tax-free increase to their £100 redemption value rather than taxable income.
Mr Denley said: “The way low coupon gilts work is surprisingly simple. If you buy a gilt below its £100 redemption value and hold it until maturity, the uplift to £100 is free from Capital Gains Tax. Because the coupon is low, more of your total return comes from that tax-free capital gain rather than taxable interest.”
By way of illustration, Mr Denley highlighted a gilt maturing in July 2027 with a gross yield of 4% that currently trades at £97.25. While the 1.25% annual coupon remains subject to tax, the £2.75 gain when the bond reaches maturity at £100 is entirely tax-free.
He said: “For a higher-rate taxpayer, that produces an after-tax return of around 3.5%. To achieve the same return from a taxable savings account, you’d need an interest rate of roughly 5.8%. That’s simply the tax system working in your favour.”
Paul Denley (Image: Newspage)
Mr Denley described the approach as particularly appealing for individuals holding considerable sums outside ISAs or pensions, perhaps following an inheritance, business sale or years of accumulated savings. He further emphasised the importance of selecting a gilt that matures at the point the funds are likely to be required.
He said: “Matching the maturity date to your spending plans removes market price uncertainty and allows you to capture the known uplift to par with confidence.”
Mr Denley added: “The higher your marginal rate of tax, the more valuable this becomes. A basic-rate taxpayer gains relatively little, but for higher and additional-rate taxpayers the difference can be meaningful.”
He emphasised that gilts were not without their risks. Should they be sold prior to maturity, their value can shift considerably, while inflation may erode the real worth of returns over time.
Nevertheless, investors who hold a suitable low-coupon gilt through to maturity know precisely what they stand to receive.
“This isn’t a loophole or an aggressive tax strategy,” Mr Denley said. “It has always been part of the UK tax system. At a time when taxes are taking a bigger bite out of investment returns than ever before, understanding how your returns are taxed can be just as important as the return itself.”