‘The current tax code is a daily mugging’ – Ronald Reagan
‘The avoidance of taxes is the only intellectual pursuit that still carries any reward’ – John Maynard Keynes
Where do you start with a subject as deep and intricate as taxation? Modern day tax codes are impenetrable even to many accountants. This means that the chances of you or I getting our tax returns right are what a race-goer might call ‘an outsider’.
If I take the UK as an example, legislation, rates, allowances and exemptions change every year. Keeping up with it all is not easy for the lay person. In fact, keeping up to date with tax laws is not terribly easy for the professional either.
With this as my guide, I am going to make a stunning recommendation as to how to handle your taxes. It is this:
Do everything you can to pay every cent or penny in taxes that you might owe.
I realise that this is not exactly creative advice but it is very sound. Only ten years ago, cheating on taxes was a worldwide sport. Everyone was involved in a little creative accounting. However, the game has changed.
Please don’t misunderstand me because tax laws were complex and confiscatory in the eighties and nineties too. But, the penalties for tax evasion are now far stronger than at any time in the past. If you live in almost any English speaking nation, it is a fair bet that penalties for tax crimes are tougher now than any time in history.
To clarify: Tax evasion is ILLEGAL and Tax avoidance is LEGAL.
This means that if you use loopholes in the law to save tax you are ok, but should you just fail to declare income you could be facing big trouble. However, tax authorities worldwide seem intent to try and blur the distinction between evasion and avoidance in the hope that in years to come, everything that saves you tax will be illegal.
In reality, this means that your choices are limited to:
a) earning nothing so creating no income to tax
b) moving to Bermuda or somewhere similar
c) paying everything that is asked of you
Paying up might not be fun, but if it saves you from a spell in prison, it is certainly worthwhile.
Tax Freedom Day
You may or may not have heard of this. In the UK, it is calculated annually by the Adam Smith Institute. Other counties will have similar calculations made.
Tax freedom day is actually calculated to give an average number of days each year that an individual must work for to clear his tax burden. Each country will differ in their actual TFD but as they are calculated worldwide, it is possible to compare like for like. Imagine that it works rather like the Big Mac Index (calculated by The Economist magazine) to compare prices of an identical product worldwide.
Many of the western nations currently have a Tax Freedom Day somewhere between early/mid May and mid July. That is a lot of days working for the government before you start for yourself.
At this point, I ought to make clear, that I am not suggesting that you seek to pay no taxes. Obviously, there are some functions performed well by government that will continue to need to be paid for. Examples would be policing and the courts, education, healthcare, public transport and many others.
However, from the perspective of the individual, saving a small portion of your annual tax bill might make a noticeable difference to your available income. If it can be done relatively easily and, of course, legally, then it is worthwhile.
Using Tax Allowances
In general, it is always wise to use all tax allowances that you can find IN FULL. This means that you should save into a pension scheme for the tax benefits (and of course, to help you to retire) and other savings schemes that allow tax free interest, freedom from Capital Gains Taxes and more.
There are some circumstances though when investment merits should stop you from making investments into tax efficient schemes. Governments have a habit of allowing very large tax allowances for investments when the investment itself has little appeal. In other words, they will use the general public, via tax incentives, to do the government’s bidding.
A great example of this can be found in the UK with something called a Venture Capital Trust.
A VCT is a way of investing in an unquoted company (at a preset date) and receiving tax breaks. The company, is small (there are limits to size), high risk, and often in the technology field. The investment is illiquid (so you cannot sell easily), has a minimum term of 3 years (so is impossible to sell before that time), usually for larger investors – £100,000 and above (so if you lose money, you lose a lot) and is regulated far more loosely than normal stock market investments.
The tax allowances are excellent (both income and capital gains tax can be offset or deferred) but in general these benefits are still not enough to make this an interesting investment. You may have saved £30,000 in tax, but if you lost £100,000 in total in the investment, it was hardly a winner.
All of the above said, a VCT can be a stunning investment as you might imagine that small, high risk, innovative companies can be very profitable. But, the tax laws surrounding such an investment are complex and don’t necessarily help the investment.
Whatever your views, it is important to use some or all of your tax allowances each tax year if you can. In fact, the best thing you can do is to buy a book about taxation and become an amateur sleuth so that you may do your own tax research.
I know that this is boring. I am truly sorry. However, it will be well worth your while. If you think about it, tax is possibly your largest monthly outgoing and as such, should probably be given a little more importance in your life. Once you understand the range of allowances, deductions and exemptions in existence, you may be able to cut a few hundred (or more) each year from your tax bill.
Going about tax reduction in this way is certainly safer than the traditional route of asking for cash payments for everything you do and hoping that you are not caught. As I said earlier, the penalties for tax evasion are very serious these days.
Most pension systems will offer some sort of income tax relief against your contributions. This is to encourage you to save (thus reducing the burden on the state when you reach retirement). They will also usually allow the funds invested to grow free (or nearly) free of tax. This will help the fund to grow more quickly and you will receive a greater benefit in your retirement.
Almost everyone that I have ever met (personally or professionally) could be doing more to aid their pension planning. This means that there are potential tax benefits available for increased pension savings to virtually all. Does this include you? If you were to save an extra 500 or 1,000 each year into a pension scheme, would your actual tax bill be reduced by 100 to 500? Sure, it costs you money, but you will reap the benefits.