Tax-efficient investing explained

When it comes to wrapping up your investments away from the taxman, an overwhelming choice of stocks and shares ISAs, all with different fees and varying investment ranges, awaits the private investor.

And how do you know which investments work best in an individual savings account? And how long will it be before George Osborne fiddles with capital gains tax (CGT) and income tax again?

Let's not forget pensions. You're probably suffering pension fatigue, as the government churns out consultation after review after consultation. Annuities, retirement age, tax relief, public sector pensions... it's hard to keep up.


The important thing to remember is that there are tax shelters available and that, in these uncertain times of tax rises and Treasury reviews, investors should pay close attention to how pensions and ISAs can best work for them.

Stocks and shares ISAs are already seeing strong inflows this year as investors lock their money away from Osborne's paws. More than £3 billion flowed into stocks and shares ISAs during the first six months of this year – the highest figure since 2001.

Investors have a £10,200 allowance that they can squirrel away in an ISA during this tax year. They can put up to half of this in a cash ISA and the rest in a stocks and shares ISA, or ignore cash and put the whole lot in stocks and shares.

According to Killik & Co, if a 55-year-old had invested the maximum permissible amount each year in a Pep/ISA since 1987 (£181,800), assuming a 5% rate of return, this would now be worth a not-to-be-sniffed-at £312,200.

In fact, one of Killik's clients has an ISA worth more than £3 million and other clients have more than £1 million wrapped up – so if you get your investments right and invest the full amount year in year out, you could become a millionaire.

You can currently invest £255,000 in a pension each year. However, the Treasury is proposing an annual contribution limit of around £40,000.

This reduced amount is plenty for most people though, especially for personal savings in a self-invested personal pension, and investors shouldn't dismiss pensions just because of the political uncertainty around them.

Pensions and ISAs can grow free of CGT and income tax. The tax relief applies to the ISA when income is taken (rather than on the way in).

Pensions work the other way around: they receive tax relief upfront, but when income is taken (through drawdown or an annuity), it is taxed at the investor's marginal rate of tax.

Lee Smythe, a partner at Killik & Co, says the ideal solution is to receive higher-rate relief on the way into the Sipp and become a basic-rate taxpayer when you need to draw income.

As ISAs and SIPPs work in different ways, it's advisable to use both. That way you've instantly got a much bigger annual allowance.


Many investors take the self-select approach to ISAs and SIPPs. This allows them to pick and choose what they want to put in a stocks and shares ISA or SIPP, normally using a simple online facility. Fund supermarkets such as Fidelity FundsNetwork offer this, as do banks and stockbrokers.

Fund supermarkets are a popular and cheap route. Chris Jordan, a director at financial planners Heron House Financial Management, comments: "They only offer a limited range of collective investment vehicles, but the ability to access funds managed by leading UK fund groups and some boutique investment houses is more than adequate for many investors. It is possible to build a well-diversified portfolio via a fund supermarket."

One downside with a self-select wrapper is that there is normally no advice given and investors must make their choices based on their own research, examining which funds have performed well and reading expert commentary, for example.

Patrick Connolly, head of communications at independent financial adviser (IFA) firm AWD Chase de Vere, warns: "Investors need to ensure they hold the right balance of investments and are not overly influenced by short-term performance or sentiment.

"In the past too many self-select investors have joined bandwagons at the top of the market or sold out of investments at the bottom."

Ian Smith, a director at Central Financial Planning, agrees: "Many consumers end up with a collection of 'flavour of the year' funds that in a few years' time look unattractive. It could be worth getting a proper, structured profile from an adviser," he says.

Some ISAs and SIPPs provide model portfolios, but these should never be followed to the letter but be used for ideas instead and tweaked according to your investment objective and risk tolerance.

Adventurous investors happy to take the self-select approach and looking for more than just a library of open-ended investment companies (OEICs) and unit trusts should consider using a stockbroker.

"More sophisticated or experienced investors may find that an online platform or stockbroker better suits their needs because they tend to offer a wider range of investments, such as shares and investment trusts," comments Jordan.

For example, the Killik & Co ISA offers bonds and UK and foreign shares in addition to funds.


Fund supermarkets normally offer a discount on the underlying funds' initial charges and Killik & Co's ISA also offers this.

However, while many supermarket ISA wrappers don't impose an annual fee (Interactive Investor and Alliance Trust Savings, for example), Killik, along with stockbrokers such as Barclays and The Share Centre, does levy an annual charge for its self-select ISA.

So the more elaborate range of investments does normally come at a price; the same is true for SIPPs.

Investors need to watch out for dealing costs, which are usually around the £10 mark. Every time a fund or share is bought or sold, a fee is triggered. Smith warns that these can mount up.

"Trading costs can eat into returns. Creating a spread of investments and then periodically rebalancing is a good idea," he notes.

Telephone dealing charges can be considerably higher than online charges for ISAs, so it really is worthwhile logging on to the internet to switch your investments rather than picking up the phone.

Although initial fund charges are often reduced (sometimes to zero) by a stockbroker or fund supermarket, investors will still have to fork out for annual fees on the funds they hold in their ISA or SIPP.

Investors should pay close attention to the total expense ratio, rather than the annual management fee, as the TER is a more accurate estimate of the annual cost of holding a fund and can be a lot higher.

There is also likely to be renewal commission, which is paid by the fund provider to the fund supermarket. Investors are unlikely to notice this cost, as it is bundled into the annual management fees for the underlying funds.

However, by using a discount broker such as Cavendish Online, this commission can be refunded back to ISA customers. Fidelity and Cofunds clients will see 100% of the renewal commission rebated back to them for a one-off fee of £25 to Cavendish Online.

Investors can use the service regardless of whether they used a financial adviser to set up their ISA and it can be used for new or existing ISAs.

For example, the annual management fee for the Invesco Perpetual High Income fund is 1.5%, but 0.5% of this is renewal commission. Cavendish Online would arrange for this 0.5% to be refunded straight back to the client.

The broker also rebates renewal commission on SIPPs held on Fidelity FundsNetwork. It keeps the first £10 of renewal commission each year and refunds the rest.

However, there is a grey area, as HM Revenue & Customs has not confirmed how the refunded commission will be taxed.

"The worst-case scenario, as explained by HMRC, is that the renewal commission may be taxable as income, although this is not the case with ISA renewal commission-rebated schemes," explains Cavendish Online's managing director, Ian Williams.

Performance fees are another cost that could eat into your tax-efficient pot of money, be it an ISA or SIPP. "Performance fees, where the fund manager will take a larger slice of any excess returns they deliver, are becoming more common," comments Smythe.

"This is OK in principle, but they don't tend to give you anything back if they do badly." Absolute return funds often involve performance fees, so be sure to read the small print carefully when choosing these funds.

Stamp duty of 0.5% is also levied on shares and investment trusts. In addition, the 10% dividend tax credit on shares cannot be reclaimed in a tax wrapper. Jordan says exchange traded funds – which are stamp duty-free – are useful if investors are looking for a cheap portfolio.

"ETFs track an index such as the FTSE 100. There is no stamp duty to pay, and because you are paying a fund manager for their stock selection skills and merely tracking the performance of a basket of shares, the TER tends to be lower."

ETFs, along with investment trusts, are not offered by all self-select providers, so investors wanting access to these will have to look for a more comprehensive ISA or SIPP.

Despite the stamp duty cost, investment trusts are worth considering, as they often come with lower TERs than funds and may boast superior performance.


Although your self-select portfolio of investments should, of course, reflect your objectives, your risk profile and your own thoughts about what asset classes or regions will perform well, you should also think about which assets will work best in a tax wrapper.

Jordan says placing income-producing funds in an ISA and higher-growth funds in a SIPP is a useful strategy. "Income from the ISA is not taxable and doesn't reduce the age allowance for those who are aged over 65.

And the potential higher-growth funds placed in the SIPP will hopefully produce a larger pension pot on final vesting, providing a larger tax-free sum from the SIPP from which to draw," he explains.

Investors should remember that they have a £10,100 CGT allowance, so if this is enough to soak up capital gains, tax wrappers should be used more for income-producing assets such as property or fixed interest, to avoid a tax bill of between 20 and 50%, depending on your salary.

If you like investing in AIM shares, these should be put in a SIPP, as they're not allowed in an ISA. "Investors should pay close attention to some of these restrictions, as it might make the process of deciding which investments are placed into which tax wrapper a little easier," comments Jordan.

Obviously, ISAs and SIPPs have more to offer higher-rate taxpayers than basic-rate taxpayers. The former will save 40 or 50% income tax rather than 20%.

But Jordan says basic-rate taxpayers shouldn't dismiss tax wrappers, as they could easily be stung by tax. "Let us consider a situation where an investor holds an investment outside of an ISA and realises a capital gain in excess of the annual allowance.

"The CGT rate has been maintained for the basic-rate taxpayer at 18%, so the gain would suffer tax at this rate.

"However, a basic-rate taxpayer could find themselves liable to 28% tax on capital gains once the gain, following the deduction of the capital gains annual allowance, is added to their income for the year and this takes them into the higher-rate tax bracket.

"Once the remainder of the basic-rate band has been used, the excess gain will be in the higher-rate bracket and subject to tax at 28%."

Jordan adds: "Placing funds in an ISA removes any doubt for investors and avoids the need for complex tax calculations."

However, Connolly says that these tax considerations shouldn't rule investment decisions. "Getting the right investments needs to come first and tax efficiency second," he advises.

Investors should also spend time reviewing their holdings. As it's self-select, there will be no financial adviser helping with this.

As well as looking at how the investments are performing, you should bear in mind your changing financial circumstances, such as how much "unwrapped' cash you might need in an emergency, and reducing the risk in the portfolio as you draw closer to requiring the capital.

"You should also consider other assets held outside of your SIPP and ISA and how any adjustments will impact on the overall balance of your portfolio," adds Jordan.

This article was originally published in Money Observer - Moneywise's sister publication - in September 2010

More about