Most individuals will be aware of their ISA allowances, which is currently capped at £20,000 each tax year.
There is also an annual pension contribution allowance, which, in order to receive tax relief on contributions, is capped at the level of somebody’s gross relevant earnings or £40,000, whichever is the lower figure. Somebody without relevant earnings can still continue to invest up to £3,600 gross into a pension.
However, not everyone will be
aware of other tax reliefs that they can access through investment products
such as Venture Capital Trusts (VCT’s) or Enterprise Investment Schemes (EIS’s).
On the whole, the first tax allowance/relief to consider when investing funds for a client will be to maximise an individual’s annual pension contribution annual allowance. If this allowance has been fully utilised, your ISA allowance should then be considered, as there is no income or capital gains tax due on funds held within an ISA.
Not everyone will be aware of other tax reliefs that they can access through investment products such as Venture Capital Trusts (VCT’s) or Enterprise Investment Schemes (EIS’s).
Thereafter, a Venture Capital Trust (VCT) can be used with a maximum investment of £200,000 available for the current tax year. Any capital invested into this product carries a 30% income tax relief that can be used to offset income tax due during the tax year you invest your funds. You must hold the investment for at least 5 years, in order to be able to retain the tax relief, and if the invested amount equates to more than the income tax due, only the tax due to HMRC can be reclaimed. Any growth on this investment is again tax-free, as are any applicable dividend payments.
Alternatively, an Enterprise Investment Scheme (EIS) offers income tax relief on the capital investment at 30%, with the option to also claim against any capital gains tax applicable, on the premise the ‘gain’ is being invested into the EIS. Over the long term, if the EIS is retained on death, the capital gains tax liability is expunged and once held for a minimum of two years, the EIS will be outside of the estate for inheritance tax (IHT) purposes, saving a potential 40% in inheritance tax.
The following scenarios illustrate how these tax advantages can be reclaimed.
An investor has a salaried income of £95,000 gross per annum and has deposit based savings worth £100,000. Their income is sufficient to cover their outgoings, and they are happy to invest £90,000 of their funds for a period of 5 years or more, to achieve capital growth. They are a higher rate taxpayer. They usually invest the maximum allowable into their pension each year but have not done so yet this tax year. They have their full personal allowance for income tax purposes.
They can therefore invest the maximum of £40,000 gross into their pension. This can be done by investing £32,000 (net) into a pension and then claiming basic rate tax relief of £8,000 from their product provider. They can claim an extension to their basic rate tax band (£0-37,700) of £40,000, meaning that £77,700 of their total income will now be liable to basic rate tax.
As a result of the pension contribution, the annual income tax liability of the investor, based on their income, will reduce from £25,432 to £17,432, a reduction of £8,000. This income tax reduction is reclaimed through self-assessment.
When considering the remaining amount of the deposit based savings to be invested, £57,107 could be invested into a Venture Capital Trust (VCT). This would essentially generate an income tax credit of 30% which would cancel out the £17,532 taxable income for the tax year. This tax credit can be reclaimed through self-assessment.
The remaining savings could be invested into an ISA, to utilise some of their £20,000 annual ISA allowance, allowing the funds to grow free of income and capital gains tax.
An investor has a salaried income of £55,000 gross per annum and has recently sold a second property for £200,000, which had doubled in value from its original investment, and so carries a capital gain of £100,000.
The investor also has an existing investment portfolio in an ISA and has already utilised their full ISA allowance by transferring the remaining capital from their Unit Trust, which utilised their full annual capital gains tax allowance of £12,300 in the process. They have utilised all of their annual pension contribution allowance for previous tax years, but still have this year’s available. They are a higher rate payer.
As the £100,000 gain applies to a property and the client is a higher rate taxpayer, then a 28% tax rate is applied. This equates to £28,000 of capital gains tax being due, as no capital gains tax allowance remains. This is in addition to the £9,432 income tax liability for the tax year.
The capital gains tax of £28,000 could simply just be deferred by investing the £100,000 profit from the house sale into an Enterprise Investment Scheme (EIS). The capital gains tax deferral can continue on until death, as long as the funds remain invested in an EIS, at which time no capital gains tax will apply.
Alternatively, the following could be done:
A £32,000 net pension contribution could be made, attracting £8,000 in tax relief. This would also extend the basic rate tax band for the investor, ensuring that all of their taxable income is taxed at 20%. This would reduce their income tax bill for the tax year by £946 to £8,486.
£28,287 could then be invested into a VCT, which, as in Scenario 1, would attract an income tax credit which would offset the £8,486 income tax liability for the tax year.
The remaining £39,713 could be invested into an EIS, deferring £11,119 (28%) of the overall capital gains tax bill due until a date in the future, or until death, at which time the capital gains tax liability will cease.
The Scenarios above are designed to highlight the importance of considering the various tax reliefs/allowances available when creating a financial plan for clients. Where a client has an accountant AND a financial advisor, it can definitely be to the client’s benefit for both of them to work together.