We have seen that it is very possible to build lifelong passive income by investing in stocks. However, tax costs can significantly cut off the amount from which we need to live.

In the UK, both dividends and capital gains are taxed. And the amount we have to pay to HMRC is getting bigger and bigger.

Here’s how I hope to avoid gigantic bills and maximize my passive income.

Growing tax bills

Dividend benefits have declined dramatically in recent years. Investors can now enjoy dividends worth just £500 before they have to start paying tax. This is down from £1,000 last year, £2,000 the year before and £5,000 just seven years ago.

Following last week’s Budget, the rate of capital gains tax (CGT) that investors must pay has also increased.

For basic rate taxpayers, the rate increased from 10% to 18%. Meanwhile, the rate has increased to 20% to 24% for higher rate taxpayers. The annual CGT allowance has been frozen at £3,000.

Tax collection may continue as the government tries to raise much-needed revenues.

ISA and SIPP

That’s why I invest using only tax-efficient products. Thanks to my Self-Investment Personal Pension (SIPP) and Shares Individual Savings Account (ISA), I don’t have to pay a penny in capital gains tax or dividend tax.

The amount I can invest in has an annual limit. This is £20,000 for an ISA and is usually equivalent to my annual income (up to £60,000) in my SIPP.

With SIPP I also get tax relief on any contributions I make. This is 20% for taxpayers covered by the basic rate and 40% and 45%, respectively, for taxpayers using the higher and additional rates.

Please note that tax treatment depends on each client’s individual situation and may change in the future. The content of this article is for informational purposes only. It is not intended to be and does not constitute any form of tax advice. Readers are responsible for conducting their own due diligence and obtaining professional advice before making any investment decisions.

Over time, using one of these tax-efficient products can save you a fortune. Let’s assume that Steve, a higher rate taxpayer, invested £20,000 a year for 10 years. During this period he achieved an average annual return of 8%, giving him a profit of £89,525.

After applying CGT allowances, £59,525 will be subject to capital gains tax. If the CGT rate remained at 24% over this period, he would pay in total £14,285 in tax.

However, the cost of these taxes to Steve would likely be higher. With less capital in the portfolio, its ability to generate compound returns would be restricted.

The best ETF

With ISAs and SIPPs, investors can also easily invest in a wide range of shares, funds and trusts. One investment I have recently added to my pension is iShares Edge MSCI USA Quality Factor UCITS ETFs (LSE:IUQA).

This exchange-traded fund invests in selected stocks “which have recorded good and stable profits in the past“. In fact, he owns a total of 124 companies Nvidia, Apple AND Visawhich in turn helps me spread the risk.

Past performance is no guarantee of future profits. And lower economic growth in the U.S. may impact what I do. However, since 2016, the fund has delivered an impressive average annual return of 14.7%.

If this happens, a £300 monthly investment in my ISA could turn into £1,113,157 after 25 years. And because I wouldn’t have to pay tax, it would give me an annual passive income of £44,526 if I took 4% of the amount every year.