Looking back home Americans believe that hard work is essential to become rich. The study shows that it is quite unlikely that somebody from the poor background will make it. Two the most common ways are: have the rich parents or get married to a rich person. The third is get into Harvard or Yale university and into finance industry. The universities prefer the kids from the rich families. This goes back in time and the example below can show how the rich are staying wealthy.
Tax efficient account in the United Kingdom
In the United Kingdom there is provision to open Individual Savings Account (ISA) for children and adults. After income taxes are paid, you can invest either in cash savings account or shares into one of the two ISAs. As long as the money stay on the account any income (interest or dividends) is tax free and no capital gains is paid on the sale.
Currently the annual allowances are: 4,368 GBP per child and 20,000 GBP per adult. From 2020 the kids’ allowance will go up to 9,000 GBP per year. When the child turns 18 years old the Junior ISA converts into adult one automatically. I put the British currency (GBP) for the reference, but please ignore throughout the text, as it is of no importance (for facts hungry, current exchange rate GBP to USD is 1.25 and GBP to EUR 1.1).
Ability of an average family’s to use the tax efficient account
Let’s look who benefits from the ISAs in the United Kingdom.
Average salary for a full-time worker in the UK is 35,423 GBP per year (27,623 GBP after taxes).
Assuming a family with two children and both parents are working. You need to have 48,736 GBP savings left to keep the ISAs full this year or 58,000 GBP from 2020 onwards.
Average of living of our family is 3,500 GBP per month, including rent or mortgage and the house taxes (council tax). The family will be left with 13,000 GBP a year of potential savings.
How is benefiting from the tax efficient accounts?
How much do they need to earn to keep their ISAs full? The family need combined income of 90,736 GBP this year or 100,000 GBP next year. This is after the income taxes are paid.
To have 50,000 GBP after taxes you need to earn 72,000 GBP per year (double the average salary). This needs to happen for both parents. To earn single handedly you need to have salary of 170,000 GBP per year. This assumes no pension contributions or any other investments.
70,000 GBP salary is top 5%, and 170,000 GBP is top 1%. The reality is that people earning 170,000 GBP a year do not live on 3,500 GBP a month while taking 8,500 GBP home. The actual threshold is even higher.
Why is it important?
The income from the ISAs is tax free. If you receive an average salary of 35,423 GBP, you will have 2,300 GBP a month after taxes. To have 3,300 GBP a month your gross income should go up by 18,577 GBP before taxes or 1,548 GBP a month.
Imagine if you had rich parents and they used Junior ISA from your birth until you are 18 years old. Even if you put no additional money, at age of 40 you still can get extra 1,000 GBP a month just as dividends tax free, while earning the average salary. It gets even better in case you maximized your ISA allowance from 18 onwards. In this case by the age of 39 you are getting the average salary for life tax free.
See the table below which has two scenarios: Investing maximum amount allowed by ISA through the life and stop investing at age of 18. I assumed 3% inflation adjusted income on investment. The money is in thousands GBP.