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.
HOW TO SELF-SELECT
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.
MIND THE FEES
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
Sometimes known as a trading ISA, a self-select ISA gives investors full control over which assets to include in their ISA, allowing them to choose individual shares and bonds rather than investment funds. Aimed mainly at experienced investors and subject to the same investment limits of a regular ISA, a self-select ISA will usually be managed by a stockbroker on an investor’s behalf.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
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.
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
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.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
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.
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.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.