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How to invest to beat the taxman: Isas | Pensions | VCTs and EIS

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The clock is ticking and you have just over six weeks to make the most of your vital annual tax allowances.

In a climate of low interest rates and modest returns from many investments, minimising the tax you pay on your savings is even more important. Should scarce money be used for pensions or Isas?

What about more adventurous options such as venture capital trusts? Is there scope to reorganise existing savings to reduce  your overall tax burden?

And should families be thinking about helping out the next generation through investments such as Junior Isas or through gifting to reduce their inheritance  tax liability?

In this special report, we look at your options for  end-of-year financial planning.

Going for growth: Sophie Blythe, with Fin, left, and Harriet, puts any spare cash into equity Isas at this time of year

OUR SPARE CASH GOES IN AN ISA

Sophie and Adrian Blythe have got into the habit of putting any spare cash into Isas at this time of year.

The couple, from Chelmsford, Essex, who have two children, Harriet, 6, and Fin, 3, review their finances in February to decide how much they can invest. Sophie, 37, who manages a charity project to encourage people to grow their own vegetables, says: ‘We see how we’re doing after the expense of Christmas and when we’ve thought about summer holidays and then anything spare gets paid into our Isas.’

She and Adrian, 38, who is a paramedic, use fund broker Chelsea Financial to help them invest in a range  of equity funds, including Rathbone Global Opportunities and Aberdeen Emerging Markets.

They invest in equities in the hope of longer-term growth, though this does mean that the value of their holdings will fluctuate with the markets.

Sophie says: ‘It is important to build some long-term savings and I will be sitting down in the next couple of weeks to work out how much to invest this year.’

ISAS

WHAT ARE THEY?

A tax-efficient way of holding cash, shares, bonds and collective funds such as unit trusts.

WHAT CAN YOU PAY IN?

A maximum of £11,280 this year, rising to £11,520 in the next tax year. Up to half of this money can be in cash with the balance in stocks and shares.

WHAT TAX BREAKS DO YOU GET?

There is no extra tax to pay on income from an Isa. It does not have to be declared on a tax return and will not count towards any personal allowances. Investments in cash or bonds pay out gross income to Isa investors.

Dividends from equities are paid after a ten per cent tax credit has been deducted and Isa investors cannot reclaim this. Any profits on Isas are free of capital gains tax.

THE PROS AND CONS

Payments can be varied as your circumstances dictate. And money can usually be withdrawn if needed.

Philippa Gee, who runs Philippa Gee Wealth Management in Church Stretton, Shropshire, says: ‘I am very pro Isas, even for a basic-rate taxpayer.

 

‘Over time you can potentially end up with hundreds of thousands of pounds on which you pay no extra tax. Isas are flexible and give you lots of choices come retirement.’

For example, money previously invested in equities for capital growth within an Isa can be switched into bond funds for income. Unfortunately, funds in equities or bonds cannot be switched back into cash, although Financial Mail has campaigned for reforms to these rules.

Adrian Shandley, managing director of Premier Wealth Management in Southport, Lancashire, says: ‘We are extremely bullish on equity Isas at  the moment.

‘We think that they should outperform cash by a long way in the years ahead. Check what a fund will charge and try to pick a manager with the scope to perform in the future, not necessarily one who has done well in recent years.’

  More... Most popular Isa funds of 2013 HOW TO PICK THE BEST ISA: Everything you need to know about cash accounts & stock market funds From CTFs to Junior Isas and just plain saving: How to navigate the tax-free schemes that boost your children's savings How to pick the best (and cheapest) DIY investing Isa How to start saving, beat the taxman and track down the best rates

PENSIONS

WHAT ARE THEY?

A tax-efficient way to put aside earnings today to produce an income when you have stopped working. Pensions may be either workplace or occupational schemes, where contributions are taken direct from your salary.

They can also include additional voluntary contribution schemes, where you top up a workplace pension; personal and stakeholder pensions run by insurers; and self-invested personal pensions.

WHAT CAN YOU PAY IN?

 

There is a £50,000 annual cap on pension contributions, which includes any money paid in by an employer. Unused allowances from up to three previous tax years can be carried forward to the current tax year. But you must have sufficient earned income this year to set against the money paid in.

There is a lifetime maximum value of a pension fund, including investment growth, of £1.5 million. If your fund breaks the limit, there is an extra tax to pay when you take money out. The annual allowance is due to be cut to £40,000 and the lifetime limit trimmed to £1.25 million in April 2014.

WHAT TAX BREAKS  DO YOU GET?

Money invested in a pension grows free from income or capital gains tax. The Government will add to money you pay in through income tax relief. For those in a company scheme, it means that contributions are taken from their salary before any tax is deducted.

Where a saver pays into a personal pension from their taxed income, the pension company can claim basic rate relief – worth 25p for every pound you pay in. Higher-rate taxpayers can then claim extra relief on their pension savings through self-assessment.

Savers cannot access any funds in a pension until at least age 55. Then, up to one quarter can be drawn tax-free with the rest being used to provide a taxed income.

THE PROS AND CONS

If an employer makes contributions or is willing to match your payments, a pension is usually the first priority. This ‘free’ extra pay makes the pension a compelling option.

Gee says: ‘There is excellent tax relief on investments into a pension. It is particularly attractive for higher-rate taxpayers who expect to be basic-rate taxpayers in retirement because they can get tax relief at 40 per cent but then pay 20 per cent on money they take out.’ For some individuals, the value of the pension tax breaks can be higher still.

Money paid into a pension will count towards reducing their overall income.

For example, this may help someone to qualify for child benefit payments, which are now reduced if a parent’s income is more than £50,000 and eliminated at £60,000. The inflexibility of a pension can be both an attraction and a turn-off. While some savers appreciate the discipline of knowing they cannot touch pension savings until 55, others dislike locking money up.

For many, the biggest disincentive to pension saving is the need to take a taxed income from the fund in retirement.

In most cases this means locking into an annuity – an income for life – which may be at an unattractive rate. Most advisers now recommend mixing pensions with other options. Gee says: ‘Pensions are simply a component of your retirement planning. They are no longer the whole answer.’

Why couples should spread the load Marital advice: Philippa Gee says couples should move what they can between them to make the most of tax breaks.

Adviser Philippa Gee says it  is essential that you review existing investments to make  sure they are being managed  as efficiently as possible.

For example, are there holdings currently outside Isa or pension tax shelters that could be sold to provide money for reinvestment into a tax-efficient wrapper?

Adviser Adrian Shandley says: ‘Each person can make £10,600  of investment profits per year before capital gains tax is due, but relatively few do. This can be a tax-efficient way to draw an “income” from your savings.’

Couples should also ensure their investments are structured to capitalise on both of their income tax allowances.

The first £8,105 of your income this year is free from tax, rising to £9,440 in the tax year starting in April. Those born before April 5, 1948 may qualify for higher allowances worth £10,500 or £10,660.

Where a husband or wife has unused allowance, it can pay to switch investments that produce  a taxed income into their name. Likewise, if one is a higher-rate taxpayer, savings should be in the name of the basic rate or non-taxpayer to reduce their tax bill. Pensions cannot be swapped around though.

Gee says: ‘You don’t want to arrive at retirement with the pension all in the name of the main earner and your spouse unable to use their personal allowance.’

One option is for the higher earner to pay into a pension on behalf of their partner. Even if you do not work and have no income, anyone aged under 75 can have £2,880 a year paid into a pension and then see this rounded up to £3,600 with basic-rate tax relief.

Help a fledgling business – and claim a 30 per cent refund

Bridging the gap: Professor Ian Jones says new ideas need cash backing

ENTERPRISE INVESTMENT SCHEMES

WHAT ARE THEY?

Specialist funds that channel investors’ money into a single fledgling or start-up business.  The investments are typically held for at least three years.

WHAT CAN YOU PAY IN?

UP to £1,000,000 per tax year.

WHAT TAX BREAKS DO  YOU GET?

There is a 30 per cent income tax refund on the money you invest, provided that you have paid at least that much in tax in the year you invest. Any growth is free from capital gains tax. Both reliefs depend on holding the shares for at least three years. On top of this, investors can choose to defer existing capital gains tax on any profits from other investments that they reinvest into an EIS.

THE PROS AND CONS

Unlike a venture capital trust, an enterprise investment scheme invests only in a single company. So each investment is potentially high risk. You have to be able to afford to lose every penny you invest.

Some managers, such as Oxford Capital, now split client investments between a portfolio  of different EIS funds to try to spread the risks.

Shandley says: ‘Historically, EIS and VCT funds have had great tax breaks but abysmal investment performance.

‘However, recently the managers have taken a more mature outlook and become more focused on returns. In the current climate, this sort of private equity fund could be a viable investment in its own right.’

Ian Jones, 57, a professor  of virology at the University of Reading who is involved in developing new vaccines, has experienced EIS investing  from two perspectives.

He has personally invested in EIS funds and he has also seen  the impact of this sort of  private equity funding in his role as a scientific adviser to two  start-up businesses.

‘In the biological sciences  there is a huge gap between the laboratory bench and the bedside,’ he says. ‘Government funding for pure research into good ideas can only go so far. Then you need someone to come in and help you take the next step.

‘There may be only a 40 or 50 per cent success rate in getting the ideas to a commercial proposition. This is why you need something like enterprise funding.

‘If the tax I pay is going to disappear down a black hole anyway, I’m happier to reclaim some of that by investing in an  EIS and to send my money in  a different direction to support  work I think is important.’

'My trusts do nicely...but some of them were real stinkers'

Undaunted: Despite setbacks, Philip Watson says his trusts pay solid income

VENTURE CAPITAL TRUSTS

WHAT ARE THEY?

Specialist companies listed on the stock market that invest savers’ money into a series of fledgling businesses. The investments are typically held for three to five years with the trust manager  active in helping the business to grow.

WHAT CAN YOU PAY IN?

Up to £200,000 per tax year.

WHAT TAX BREAKS  DO YOU GET?

There is a 30 per cent income tax refund on the money you invest, provided you have paid at least that much in tax in the year you invest. And dividends paid by the trust are free from income tax, but investors have to hold the shares for at least five years to qualify for these reliefs. Any gains on the sale of the shares are also tax-free.

THE PROS AND CONS

Darius McDermott of discount broker Chelsea Financial Services, which markets VCTs, says: ‘Investing in smaller, unquoted companies can add  a layer of diversification to your overall portfolio. And some trusts now have a  record of paying consistent tax-free dividends going  back 15 years.’

Michael Probin, a director of Isis Equity Partners, which manages the Baronsmead range of VCTs, says: ‘In this climate, natural economic growth isn’t going to bring big returns. We’re looking for the companies that are nimble enough to thrive in a flat economy and then to help them to grow.’

But Philippa Gee is more cautious about the risks of VCTs. ‘I urge huge amounts  of caution on these funds,’  she says. ‘Yes there are tax savings, but what is the point if you lose a slice of your capital or find it hard to sell the shares in future?’

Liquidity problems – a lack of buyers for those who want to sell shares – have been an issue for some VCTs in the past. Some trusts now provide guaranteed buyback schemes, which pledge to buy shares back at either a five or  ten per cent discount to their net asset value.

Retired insurance broker Philip Watson has been a VCT investor for more than a decade. Philip, 64, first put money into the trusts in 2000 after he sold a business. He made further investments over the next few years, building up a broad portfolio of holdings, and has shares  in trusts run by managers including Northern, Matrix and Baronsmead.

Philip, a keen rambler who lives near Farnham, Surrey, with his wife Annie, says: ‘I’ve had one or two real stinkers that have lost 90 per cent of my money but generally I am doing very nicely out of the income from my trusts.

‘Most of the funds are well established and now concentrate on paying a regular and solid income that is tax-free for me.

‘I like the fact that these funds are supporting growing British businesses,’ he adds.

The VCTs sit alongside  a portfolio of Isas and his  self-invested personal pension.

VCTs differ widely and are managed with different objectives. Some focus on particular industries or themes, while others spread their holdings across a range of business areas.

Increasingly popular are ‘limited life’ VCTs. Here the portfolios are managed with the intention of returning investors’ capital in the fifth or sixth year.

That way the investments still qualify for the tax breaks, but savers have more certainty around the return  of their money.

Because they are managed with this ‘exit’ in mind, limited life VCTs have different risks to general VCTs.

DON'T FORGET TO KEEP AN EYE ON YOUR PORTFOLIO

Regardless of which tax shelter you use, it is essential to monitor and review how an investment is performing.

If you work with a financial adviser, regular reviews are part of the service you pay for.

But investors who prefer to make their own decisions need DIY reviews.

Technology is making that much easier. Most of the main discount brokers and fund supermarkets have been improving the services and online tools they offer to customers to help them keep on top of their money.

The support can include fund filters. These allow savers to sift through the thousands of funds available, reviewing them on the basis of criteria such as investment sectors, past performance and charges.

Another option is guided fund selection. Investors answer a series of questions through an automated review process that then suggests potential sectors or funds.

Fund broker Bestinvest last year introduced First (Free Investment Report Service and Tools). This allows users to benchmark their investments against measures such as cost and performance, as well as giving them an overall assessment of how assets are allocated across their holdings.

You can get an instant result online at bestinvest.co.uk/first or download a form to fill in and submit by post.

Such investment tools can also help you with your overall investment strategy.

Fidelity, for example, has an online ‘myplan’ service that suggests what proportion of your savings should be invested in which types of assets, depending on the answers to questions on your goals and your attitude to risk.




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