There has been a lot of focus on investing for income over the past couple of years.

This is mainly because income levels (yields) are generally down on where they were a few years ago. Dividends are lower because companies are generally seeing some tough times, and interest payments are lower from bonds and gilts as their prices have risen.

Therefore the search for income has taken on a new level of popularity. So here is a quick guide to how income is taxed and what you can do to avoid it.

Dividends are paid by companies to their shareholders. Individuals are liable to 10% tax on dividends at the basic rate of income tax, 32.5% for higher rate taxpayers and 42.5% for additional rate taxpayers.

However, if you hold equity funds (funds that invest in companies) via an ISA or Pension then you are not liable to any tax on these dividend at all. There is a 10% tax deducted at source though that cannot be reclaimed. That means if you hold investments through an ISA and receive dividends from the equity funds you invest in, you will not actually pay tax on that income. In fact, you do not even have to declare the income to HMRC.

Interest can be paid on holdings of corporate bonds or Government gilts. As these are effectively loans to a company or the Government you are owed interest by investing in them. This will be taxed at 20% for basic rate income taxpayers or 40% for higher rate taxpayers, and 50% for additional rate taxpayers. This is in the same way as you would be taxed on interest earned on cash savings in the bank or building society.

However the good news is that if you hold these ‘fixed interest’ funds via an ISA or Pension, the same rules apply as outlined above.

An important point to note if you are buying funds is that you will often have the choice of buying ‘Inc’ or ‘Acc’ units in a Unit Trust or OEIC. The selection you make is very important.

With ‘Acc’ or accumulation units, any income generated by the fund you have invested in will automatically be reinvested to buy more shares within the fund. That is, the income will never leave the fund. This helps to increase the value of your units.

With ‘Inc’ or income units, the income will leave the fund and be paid to you. Now you might never see this income because it can either be paid out to you or be automatically used to buy more units in the fund.

The difference between these units really affects how you manage, or someone else manages, your investments.

There are reasons for holding either or both types of units so you should get specialist investment advice before buying.

However the important point to note is that income generated by these funds will be liable to your personal income tax regardless of whether you invest in Income or Accumulation units. So for higher rate taxpayers there is an extra liability to income tax if these funds are held outside of tax efficient wrappers such as an ISA or Pension.

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Blog by Jaskarn Pawar

Jaskarn Pawar is an experienced and award winning Chartered and Certified Financial Planner. He advises people all over the UK on financial planning and wealth management issues to help them reach solutions to fit their personal needs. You can contact Jaskarn on 01604 211234 or by e-mail on jaskarn@investorprofile.co.uk