Intelligent investing requires good knowledge of the wider tax implications of your interests.
The ways in which investment vehicles are treated by the tax system is a crucial consideration as you weigh up the various propositions available to you.
Tax efficiencies can help to both maximise your returns and mitigate your exposure to risk.
Clearly, your financial circumstances and wealth goals will dictate which tax incentives are most appealing to you.
If you are in the 40% income tax bracket as a higher earner, any ways of investing that reduce your income tax may be top of your agenda.
Or perhaps you are approaching later life and seriously considering your wealth transfer options. Being able to pass on your hard-earned wealth to loved ones, while minimising the amount which is wiped out through inheritance tax, could be your primary concern.
Another common motivator for seeking greater tax efficiencies arises when investments are successfully exited or realised.
Investors may look for ways of deferring or receiving relief on a looming capital gains tax bill.
Also, a large capital sum presents an opportunity to generate income for your portfolio. Doing so while remaining tax efficient is key. Through some capital investment vehicles, the tax incentives can be highly attractive.
Whatever the impetus for your search for greater tax efficiencies from your investments, there are lots of options open to you - and the below offers a brief introduction to just some of the most popular.
Individual Savings Accounts (ISAs)
ISAs enable tax-free savings and are popular among taxpayers across the wealth spectrum. Neither interest made on cash in an ISA or income/capital gains from ISA investments is subject to tax.
The longest established ISA types are cash, and stocks and shares, while others have emerged more recently, including the ‘innovative finance’ and ‘lifetime’ ISAs.
Cash ISAs generate returns on savings via their respective interest rate, while stocks and shares ISAs are a means of investing in listed companies, investment funds or corporate and government bonds.
There is no tax on any capital gains they generate, which makes them particularly appealing to those who exceed the £12,000 annual capital gains tax allowance. Income from bonds is also tax free – as are any dividends received. Importantly, such dividends do not impact on your annual tax-free dividends allowance (which was set at £2,000 from April 2019).
Innovative finance can cover peer-to-peer loans (lending to companies and individuals outside of the banking system) and ‘crowdfunding debentures’ (investing in businesses by acquiring their debt)
The lifetime ISA is designed to support people in either buying their first home or saving for retirement.
They allow you to save £4,000 each year, from the age of 18 to 50, with the government adding a 25% bonus to your savings, up to a maximum of £1,000 per year.
The annual ISA allowance as of the 2019/20 tax year is £20,000, which can be spread across multiple ISA accounts.
While access to your ISA funds may be restricted, flexible ISAs from which funds can be withdrawn more readily are also available.
Following sweeping pension reforms in the UK over the last decade, pension savers can typically withdraw up to 25% of their pension funds as a tax-free lump sum from age 55.
Pension investments are not subject to capital gains tax, while regularly received pension payments are liable to income tax.
This is subject to the standard tax-free personal allowance (currently £12,500) and the relevant basic, higher or additional tax rate.
Tax relief is offered on pension contributions based on your relevant income tax level.
Higher rate taxpayers, for example, receive 40% relief on their contributions, giving a £1000 contribution a real cost of £600.
Business Property Relief (BPR)
This is relevant to investors considering how to pass on their wealth to loved ones tax efficiently. It enables certain investments to be passed on free from inheritance tax upon the death of the investor, as long as they have been owned for at least two years.
Not all business investments qualify for BPR. Those that do include companies that are either not publicly listed, part of the AIM market or are a partnership. Also, ISAs that enable investment into the AIM market can also qualify for BPR on top of the other ISA-related tax benefits.
Given that inheritance tax is 40% on assets above the threshold of £475,000 – or £325,000 minus the £150,000 ‘main residence’ band – BPR is certainly worth pursuing as an investor in later life.
Venture capital trusts (VCTs)
VCTs are listed companies which serve as a vehicle to invest in usually smaller, unquoted companies.
They are run by a fund manager and offer tax relief as a carrot to entice backing for higher risk businesses. Income tax relief is offered at a rate of 30% on investments worth up to £200,000 in newly issued VCTs. Shares in the VCT must be kept for up to five years to keep the tax relief.
Earnings from the sale of VCT shares at any stage are not subject to capital gains tax.
The Enterprise Investment Scheme (EIS)
Like VCTs, the EIS encourages investors to support the growth plans of ambitious businesses – while taking advantage of generous tax reliefs and incentives, and targeting potentially strong returns.
Individuals who invest in an EIS-eligible firm receive a reduction in their annual income tax bill worth 30% of the value of their investment. This can be used in the year of the investment or carried back one year.
With an investment cap of £1m per tax year – or £2m if at least half is invested into ‘knowledge-intensive’ businesses – the financial benefits are considerable.
EIS also offers capital gains tax exemption on profits earned on shares held for at least three years. Other tax benefits include loss relief, should the company you’ve invested in fail, and capital gains deferral.
This is delivered when gains realised on the disposal of any asset are reinvested in an EIS eligible enterprise. Also, EIS investments are inheritance tax-exempt, when they have been held for at least two years.
The Seed Enterprise Investment Scheme (SEIS)
The SEIS takes the tax benefits of EIS to another level, in return for the generally higher risk nature of the early stage firms it applies to.
Only startups that began trading in the last two years, have 25 staff or less and no more than £200,000 of gross assets qualify for the scheme.
The SEIS promises investors initial income tax relief of 50% on investments up £100,000 per year in each company. No more than a 30% stake in any business can be acquired to qualify.
A capital gains tax exemption applies on gains realised when assets are disposed if they are reinvested through SEIS in that year.
Making tax efficient investments
Very much a high level overview of some of the ways to invest tax efficiently here in the UK, the whole focus of this piece is to highlight just how many options are available.
And whilst we're strong advocates of tax efficient investing, all such routes should always be carefully considered before you make an investment. Tax relief rates and eligibility criteria can vary, incentives may change from year-to-year and the best way to be certain you're getting the most from your tax efficient investments is to take the advice and guidance of a professional adviser, as they'll help you to find the ideal investment strategy and structure for your tax needs.