How can you assemble an investment portfolio that meets your needs and maximises tax efficiencies?
The approach you have to investing will always be determined by your financial preferences.
Taking financial advice should be a given, but understandably it can sometimes bamboozle you with complex jargon that channels you towards a specific product.
However, the fundamentals of your investment preferences are more intuitive than this may lead you to believe.
This post will introduce you to a common distinction between growth and income, interpret their relevance to you, and explain how you can capitalise on tax incentives offered by the UK Government in pursuit of this.
Introducing income and growth investment strategies
Financial advice often refers to a difference between investments structured to deliver income and those structured to deliver growth. This distinction is sufficiently pervasive for investment products to be named 'Growth Funds' and 'Income Funds'.
The nature of a fund is that it is managed by an accredited investment company on your behalf - an investment manager selects which individual companies to invest in and charges a fee in return for this service.
If you feel you have sufficient knowledge and experience of investing, you can invest directly in individual companies and create a portfolio that is designed to achieve growth or income.
Investment funds that seek to deliver income will typically gravitate towards investing in more mature companies that have recorded consistent profitability. These companies are not averse to future growth, but they have achieved a strong market position and their focus is on maintaining performance.
Many of these companies are recognisable brands. Not having to reinvest profits in pursuit of business growth enables these companies to pay more significant, regular dividends to shareholders - and it's these dividends that represent the primary income to you as an investor.
Investment funds seeking to deliver growth are more inclined towards younger businesses that are still establishing market position. These companies are typically more volatile - they offer higher growth potential, but also higher likelihood of losing value.
A fund can mitigate this risk by ensuring the companies into which it invests are diverse. Profits generated by companies of this type tend to be reinvested in pursuit of ambitious growth strategies. Consequently, dividends are typically less regular and less generous.
It's important to understand that these two scenarios are not mutually exclusive - established companies can still achieve growth and emerging companies can still return dividends.
Nevertheless, the two propositions are sufficiently distinct for you to consider them separately and determine which is suitable for you.
What should determine whether income or growth investments are right for you?
Your current financial circumstances will be influential in your decision.
But arguably more influential – and often directly linked – will be your financial outlook.
The simple matrix below sets out a basic interpretation of how you might approach this. The most distinct quadrants are scenarios where you have high current earnings and a long-term outlook, or you have modest current earnings and a short-term outlook.
High current earnings and a long-term outlook
If your current earnings support your lifestyle, you are less likely to require additional income. Chances are you are working hard and may be thinking about your future financial wellbeing.
People in this category are typically early-/mid-career professionals. Their longer-term outlook supports investing for growth - they perhaps don’t have a large capital sum to invest up front, but expect to be able to top this up on a regular basis.
Crucially, they can afford for the value of their investment to fluctuate in the short-/medium-term, provided it increases in value in the long-term. This provides a good match with the turbulence that investment funds seeking to deliver growth are likely to encounter.
Modest current earnings and a short-term outlook
People in this category are typically recent retirees. They may have a capital sum to invest, either taken as a lump sum of up to 25% of their pension or accumulated over the course of their working life.
Their financial outlook, influenced by their age, is likely to be more short-term and they will be keen to invest their capital in a product that provides an income to supplement their pension. In contrast to those seeking growth, the short-term outlook of those seeking income is less compatible with investments that fluctuate.
How can tax efficient investing support your ambitions?
The tax status of various investments should be a key consideration, both for those investors focused on growth and those focused on income.
For example, investors on high incomes (and already paying higher-rate or additional-rate income tax) may find the value of additional income is severely constrained by the tax liability it generates.
There are a range of tax incentives available to UK investors (which we've catalogued in our free e-guide), and the below highlights a selection of the incentives most relevant to the two investment profiles outlined here.
If your investments grow in value, your greatest concern will most likely be capital gains tax.
If your investment increases in value – which an investment fund that seeks to deliver growth will prioritise – this increase is classified as a capital gain and is subject to capital gains tax.
You have an annual capital gains tax-free allowance (£12,000 in 2019/20), after which the rate at which you pay capital gains tax is determined by your income tax band.
If you are a standard-rate tax payer, your rate of capital gains tax on business investments will be 10% (and 18% on residential property). If you are a higher-rate or additional-rate tax payer, your rate will be 20% (28% on residential property).
Venture Capital Trusts (VCTs) represent a good fit. VCTs are managed funds and are structured in a variety of ways to meet your objectives - many are described as Growth VCTs. VCTs may be suitable because:
- Investments must be held for a minimum of five years to qualify for tax incentives. This requirement suits those with a long-term financial outlook.
- All tax incentives described here are limited to the first £200,000 invested in a VCT by an individual per financial year. This restriction suits those looking to build their investment incrementally.
- All capital gains remain tax free, whenever they are realised, and do not impact upon your annual capital gains tax-free allowance.
- Furthermore, dividend payments are also tax-free and you can claim income tax relief worth 30% on your initial investment.
Investing in companies that qualify for the Enterprise Investment Scheme (EIS) or the Seed Enterprise Investment Scheme (SEIS) also represent a good option. Although these investments are more typically direct investments in individual companies, EIS funds are becoming more popular.
- Investments must be held for a minimum of three years to qualify for tax incentives. This suits those with a long-term financial outlook
- All tax incentives described here are limited to the first £100,000 invested in an SEIS-eligible company by an individual per financial year (EIS-eligible companies are up to £1,000,000), suitable for those looking to build their investment incrementally
- Like VCTs, EIS and SEIS investments also offer tax-free capital gains that do not impact upon your annual capital gains tax-free allowance
- Also like VCTs, income tax relief is available on your initial investment at a rate of 30% for investments in EIS-eligible companies and 50% for SEIS.
During the 2017/18 financial year you can access a £2,000 tax-free dividend allowance. Reduced to £2,000 from £5,000 in 2018.
Once this allowance has been exhausted, dividend payments are taxed depending on your marginal rate of income tax - 7.5% if you are a standard-rate tax payer, 32.5% if you are a higher-rate tax payer, and 38.1% if you are an additional-rate taxpayer.
Venture Capital Trusts (VCTs), outlined above, do offer tax free dividends that would appeal to an investor seeking income from their investment. However, the tax incentives available to an individual are restricted to the first £200,000 invested into a VCT in a financial year.
This is therefore less suitable for someone who has a larger capital sum to invest immediately. VCTs are also required to invest a minimum of 70% of their value in early-stage companies, which tend to be riskier investments.
An alternative tax-efficient option for an investor pursuing income is to invest through an Individual Savings Account (ISA). ISAs are arguably the most well-established tax-efficient financial product.
- Cash ISAs in theory offer an income through interest payments. However, the value of interest payments currently reflects the Bank of England’s base rate, which is currently at an historically low level. Deposits in Cash ISAs are also protected through the Financial Services Compensation Scheme (FSCS), which makes them zero-risk provided no more than £85,000 is deposited with an individual provider.
- Stocks & Shares ISAs offer tax-free dividends that do not impact upon your annual tax-free dividend allowance. Capital gains achieved within a Stocks & Shares ISA wrapper are also tax-free. Stocks & Shares ISAs can invest in the full spectrum of equity products and can therefore offer tax-free dividends from even the most established listed companies; this contrasts with VCTs, which must invest a minimum 70% in early-stage companies.
- However, the amount that you can invest within an ISA wrapper is limited to £20,000 per financial year across Innovative Finance ISAs (IFISAs), Cash ISAs and Stocks & Shares ISAs combined. This makes the ISA less suitable for someone who has a larger capital sum to invest.
It could be that a portfolio that prioritises income is achieved through combining investments in two separate products, such as a VCT and a Stocks & Shares ISA.
Making the decision
As with many investment-based decisions, there's no blanket answer here. Some people will prefer - or need - investments that have the focus of producing an income quickly, whilst others will have a longer focus and want investments that have future growth potential.
The decision lays with you as an individual, and should be based entirely on your needs - suitable tax efficient investment strategies exist for everyone, and the decision between growth and income is one that should become increasingly clear when you determine your immediate, medium and long term financial goals.