Invest and keep the taxman at bay
In this era of austerity and economic uncertainty, any investment gains are hard won, which is all the more reason to take advantage of any tax breaks available.
Tax-efficient wrappers come on a sliding scale of complexity, from individual savings accounts (ISAs) through to pensions, investment bonds, venture capital trusts (VCTs) and enterprise investment schemes (EISs). So how can you capitalise on HM Revenue & Customs' (rare) generosity?
INDIVIDUAL SAVINGS ACCOUNT
ISAs tend to be the bread and butter of tax-efficient investing. They are simple, flexible and can house a range of investments, from funds and shares to cash. Investors can put up to £10,680 a year in a stocks and shares ISA (£5,340 in a cash ISA) and the money will be exempt from capital gains tax (CGT) and income tax.
Income tax on dividends is taxed at 10% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 42.5% for top-rate taxpayers. In comparison, the capital gains tax (CGT) rate is 18% for basic-rate taxpayers and 28% for higher-rate taxpayers.
ISAs are increasingly being used as an alternative vehicle for retirement savings. For pensions, the tax breaks come on the way in, but all income taken from a pension over and above the 25% tax-free lump sum is taxable. In ISAs, investments are made out of taxed income, but the income on the way out is tax-free.
You will have to decide whether it's worth foregoing the tax relief on the way in, to pay no tax on the way out.
ISAs also have the advantage of being entirely flexible - investors can take their money out at any time and reinvest it as they wish. But remember, you can only deposit £10,680 each tax year (the limit will increase annually) regardless of what you take out.
If you put your whole allowance in at the start of the tax year, for example, and then withdraw £500, you can't put it back in later in the year.
That said, pensions are still the most common way to save for retirement.
The current tax rules are that basic tax relief is automatically added to all individual pension contributions by the government. Those contributions can be into a company or personal scheme. Higher-rate taxpayers can claim a further 20% through their tax return.
However, there are restrictions on the tax relief available for those whose total annual income is over £130,000.
Once in a pension, contributions roll up free from CGT and income tax. Pensions are subject to annual contribution limits (£3,600 or 100% of earnings up to £50,000, whichever is greater) and lifetime limits.
On retirement at 55 or above, investors can take a cash-free lump sum of up to 25% of the pension pot. They no longer have to buy an annuity or retirement income with the remainder, but will have to pay tax on any income generated.
For most of us paying into company pensions, it may seem as though our options are restricted, but self-invested personal pensions (SIPPs) indicate there's greater flexibility now on offer.
While standard personal pensions may be cheaper, they will have a limited range of investment options compared with SIPPs, which provide the broadest range of investment options.
So-called 'low-cost SIPPs' offered by fund supermarket groups such as Fidelity Funds Network or Hargreaves Lansdown will offer access to individual shares, funds, exchange traded funds and investment trusts, while more sophisticated SIPPs may also offer access to commercial property and can be used to shelter business assets.
"The price you pay for tax-efficiency can be to limit where you invest your money," says David Jeal, head of product management at Selftrade.
"But with a SIPP there's no restriction. You could even invest in CFDs (contracts for difference) and unquoted shares."
VENTURE CAPITAL TRUSTS
Venture capital trusts (VCTs) have garnered more attention recently as another potential alternative to pensions, particularly among wealthier investors for whom pensions are no longer as attractive. These invest in fledgling businesses and attract significant tax breaks.
Any investment up to £200,000 into a new VCT gives immediate tax relief of 30%. There's also no CGT on redemption and no income tax on any distributions.
The investments contained within VCTs tend to be early-stage companies and, as such, are relatively high risk. Nevertheless, a number of VCTs have performed extremely well.
The 30% tax relief is often the difference between an investment losing or making money. For this reason, although VCTs can complement a portfolio, many experts are wary of using them as an alternative to pensions or ISAs.
ENTERPRISE INVESTMENT SCHEMES
Cousins to VCTs, enterprise investment schemes (EISs) were similarly created to promote investment into smaller businesses, but be aware that along with the attractive tax incentives comes a high level of risk.
The schemes invest in early-stage companies, offering an exciting, tax-efficient opportunity for a small part of an investment portfolio. There are stringent limits on the type of companies in which these schemes can invest, though these rules were loosened in the recent Budget.
The tax advantages of EISs fall into four main categories. The first is income tax: investors receive tax relief on their investments into an EIS in the same way as they would with a pension, with limits up to £500,000.
The second is CGT deferral: investors' gains from sold assets can be rolled into an EIS and CGT payment deferred until after the EIS is sold. Also, there is no CGT payable on any gains as long as they are held for three years or longer.
Finally, EISs held for over two years are also exempt from inheritance tax.
BED AND ISA/SIPP
Bed and ISA or Bed and SIPP are means to save capital gains tax. Everyone has a capital gains tax (CGT) allowance every year (for 2010/2011 it was £10,100). For 2011/2012 it's £10,600.
One of the best ways to save CGT is to make use of this allowance every year. But investors may not want to sell out of their investments: normally, if you sold investments to use your allowance, you could only re-buy the same investments 30 days later.
The Bed and ISA or Bed and SIPP process, however, means that you can sell the 'unwrapped' fund today, use your allowance, and then buy back within an ISA or SIPP wrapper immediately.
Although it may be sexier to hunt out the top-performing smaller companies stock or take a punt on China, making optimum use of tax wrappers is perhaps the smartest way to increase your wealth over the long term.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
Venture Capital Trusts were introduced in 1995 to encourage private investments in the small-company sector by offering tax relief in return for a minimum investment commitment of five years. A VCT is a company, run by a fund manager, which invests in other companies with assets of no more than £7m that are unlisted (not quoted on a recognised stock exchange) but may be listed on the Alternative Investment Market (AIM) or plus with the aim of growing the companies and selling them or launching them on the stock market. Investors in new VCTs are offered desirable tax advantages and VCTs themselves are listed on the London Stock Exchange, with strict limits laid down by HM Revenue and Customs on what they can invest in and how much they can invest.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.