If you’ve recently found yourself thinking 'what happened to my £13,500 tax efficient investment? How can I get it back?’ chances are you've been affected by the annual restriction on your pension contribution.
If you earn £150,000 per year or more, a sharp reduction in the annual amount you can contribute to your pension was introduced in April 2016.
It is entirely possible you are not aware of this change - but by the end of this blog post you'll have an understanding of the role of pensions in tax-efficient financial planning, where that £13,500 went, and how you can go about identifying alternative investment opportunities that offer tax incentives which exceed those previously available through your pension contributions.
People currently earning up to £150,000 can contribute up to £40,000 per year to their pension.
The value of this is enhanced by its tax status; individual tax relief on pension contributions is an established pillar of the UK personal taxation framework - it will celebrate its centenary in 2021, having first been introduced in the 1921 Finance Act.
For those paying higher-rate income tax (earning a salary of over £45,000 [£43,000 in Scotland] in 2017/18) this tax relief is worth 40% of the contribution; the real cost of contributing £40,000 to a pension is £24,000.
For those paying standard-rate income tax, this is worth 20% of the contribution; the real cost of contributing £40,000 to a pension is £32,000.
For each £1,000 you earn above £150,000 per year, your annual pension allowance now reduces by £500, until it falls from £40,000 to £10,000, at which point you will be earning £210,000.
This £10,000 pension contribution continues to qualify for tax relief and therefore costs you just £5,500.
Despite this, the restriction to your allowance deprives you of a further £30,000 available at a real cost of just £16,500.
If you were able to still make pension contributions at your previous level, you would be entitled to tax relief to make up the difference: £13,500.
So, how else could you achieve this level of tax efficiency? Let’s look at your options.
Alternative tax-efficient investment options
Investment products that offer tax relief at the point of investment are well established.
Known by HMRC as the Venture Capital Schemes (of which there are three), all of the schemes offer tax relief way beyond the initial point of investment:
- Venture Capital Trusts (VCTs) are managed investments that are tradable on regulated exchanges. This gives them superior liquidity, and they offer tax-free growth and tax-free income, in addition to tax relief at the point of investment.
- The Enterprise Investment Scheme (EIS) is an accreditation that individual early-stage businesses seek; it offers investors tax-free growth, Capital Gains Tax (CGT) reinvestment deferral, Inheritance Tax (IHT) exemption and downside protection, in addition to tax relief at the point of investment. Download your free guide to EIS investing.
- The Seed Enterprise Investment Scheme (SEIS) is similar to the EIS, but accreditation is restriction to very early-stage businesses. It also offers investors tax-free growth, CGT reinvestment relief, IHT exemption and downside protection, in addition to tax relief at the point of investment. Download your free guide to SEIS investing.
In terms of tax relief at the point of investment, investments in VCTs and EIS-eligible businesses offer 30% income relief, provided you have paid sufficient tax, your investment is held for a minimum term of five years (VCT) or three years (EIS), and remains within annual investment limits of £200,000 (VCTs) and £1,000,000 (EIS) per financial year.
Although this incentive is welcomed, it remains inferior to the tax-relief you were previously able to access through pension contributions.
Investments in SEIS-eligible businesses, however, attract tax relief at the point of investment of 50%, provided you have paid sufficient tax, your investment is held for a minimum term of three years, and remains within the annual investment limits of £100,000 per financial year.
The SEIS: does the taxman really match your investment pound for pound?
If your primary ambition is to achieve tax relief equal to or in excess of that previously available through your pension contributions, an SEIS investment is the option best able to meet this.
To replace your £30,000 pension contribution with a £30,000 SEIS investment will cost you just £15,000.
This is a superior rate of tax-efficiency than offered previously by your pension contribution, but the tax-efficiencies offered by your SEIS investment do not end there:
- If you have a capital gain that has generated a CGT liability, you can half your CGT bill by reinvesting this gain in an SEIS-eligible company. If you had a taxable gain of £30,000, you would face a CGT bill of either £6,000 or £8,400 depending on the source of the gain. You could half your bill – to either £3,000 or £4,200 – by reinvesting this £30,000 in an SEIS-eligible company.
- Should your investment increase in value, this can be realised free of CGT; preserving your annual CGT allowance and saving you from paying CGT at 20% on gains beyond that allowance.
- Should your investment decrease in value, you can claim loss relief on your real investment at a rate of 45%. If the value of your £30,000 investment fell to zero, you could claim loss relief of £6,750 on your £15,000 real loss. If you’ve also accessed CGT reinvestment relief, your net loss could be contained at £4,050; representing capital at risk of just 13.5%.
- Finally, your investment in an SEIS-eligible company will be exempt from IHT were you to die, provided that it has been held for two years prior to your death. IHT is charged at a rate of 40% on all qualifying assets above your personal allowance (formally your nil-rate band), which is £325,000 in 2017/18.
Your investment in an SEIS-eligible business must be held for three years to access the tax incentives outlined above.
Provided you have held the investment for three years, you are free to sell the investment whenever you like; in this sense, your investment offers greater liquidity than pension contributions.
What to do next
We are keen advocates of tax-efficient investing, particularly through EIS-eligible and SEIS-eligible companies.
Our GrowthFunders investment platform hosts opportunities in which you can participate, we have a growing knowledge library that provides insights on everything from tax efficient investing on a high level through to the specifics of IHT, and we are always happy to discuss tax-efficient investment - just get in touch!