The answer lies right at the heart of how they have structured their investments in the first place. Whilst low interest rates are good for borrowers, they create difficulty for investors and savers alike.
Cash held on deposit which earns interest, will be assessable for income tax whether it is used for income or not. The amount of tax payable will be determined by the total taxable income in the year. There are scales of tax and the more you earn, the higher the scales are likely to be.
I agree that we should all keep some funds readily available on deposit but these should be kept in most cases to a contingency reserve amount rather than representing the majority of the available capital. Of course, many people rely on regular income from their capital. Short term income requirements can be achieved by setting aside some capital to be spent as income. Whilst you may think this reduces the amount of capital overall because of the amount being spent, this is not actually the case if the balance is invested with a view to replacing that capital.
If the invested capital is held within an appropriate investment, the value of any gains will simply roll up without creating any taxable income. This is often referred to as tax deferral. It is true; the tax is only being deferred until such time as the money needs to be withdrawn. At that point it becomes assessable for income tax. So does it really achieve a saving? In fact it does because of the way that the gain is assessed.
LetÂ’s compare a deposit account with a tax deferred investment. Â€120409.39 on deposit which earns gross interest of Â€3612.28 will attract income tax of Â€758.58 euros at 21% and is payable whether the interest is used for income or not. Â€100,000 in a tax deferred investment which grows in value in a year by Â€3612.28, from which Â€3612.28 is withdrawn for income, will only attract tax of Â€22.08 assuming the same rate of tax at 21%.
Is that possible? Indeed it is! The best way to explain why is to look in detail at how the tax is calculated. When interest is earned on a deposit account, it is all taxable. If the tax deferral investment was fully encashed at the end of the first year, the full gain would also be taxable. However, in our example, we are withdrawing 3612.28 euros, which is only a small proportion of the total investment. As such, the proportion of gain is assessed by reference to the whole bond value at the time of withdrawal versus the initial investment.
Of the Â€3612.28 withdrawn, Â€3507.12 is simply a return of some of the initial capital and the balance of Â€105.17 is the taxable gain. At 21%
this amounts to tax of Â€22.08 euros.
There is no time limit on how long gains can be deferred and consequently, with careful planning, you too could opt not to pay income tax on your investments this year!