Having a proper grip on your tax affairs can bring significant rewards. To help, Faith Glasgow explains when you should use them and how.
For most people, allocating money to specific goals is a big challenge. It’s much easier to keep a general all-purpose account, whether that’s cash or investments, and use it for whatever comes along.
Nonetheless, there are various scenarios in which money is being saved for a very particular purpose – and in many cases there is a handy tax-efficient ‘wrapper’ to make use of.
Using the right tax wrapper means you’ll get some kind of tax break, either immediately or in the future, on the money you invest. It also means that your investments can grow free of all tax within the wrapper, which can make a massive difference to the value of your investment over the long term.
Vanguard gives the example of £20,000 a year invested into a global fund growing at 5% a year within a tax wrapper for 10 years, compared with the same investment made in a taxable account. Factoring in dividend, savings and capital gains tax allowances, if you sold the fund after 10 years, it would be worth over £8,000 more in the tax-efficient account than in the taxable equivalent.
And if you use the best tax wrapper for your purpose, that leaves other allowances free to allocate more cash to. For instance, if you open a Junior ISA, you don’t have to put money aside into your own ISA for your child’s future so you can use the full £20,000 ISA allowance for other purposes, if you’re lucky enough to have that much spare cash.
So here we’ve identified 10 financial targets and the best tax-efficient account for each one. Some may be obvious, others much less so.
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1) Saving for short-term goals
It could be a wedding, a house extension or a world cruise: whatever you’re saving for, you want to keep your money separate from your other funds and pretty easily accessible, and you want to use it within the next five years or so.
For most people that means a cash account. Interest rates are currently so low that if you’re saving only a relatively small amount, you’ll probably do better using a taxable regular savings account because the rates are better.
Moreover, you’re unlikely to earn enough to be taxed. The personal savings allowance enables basic-rate taxpayers to earn up to £1,000 of savings interest in a taxable account without paying tax, while higher-rate taxpayers can earn up to £500.
Moneyfacts shows a top regular savings ISA rate of 1.45% from Vernon Building Society. In contrast, Nationwide is paying 2.5% on its taxable Flex Regular Saver account (with certain limitations); you’d need to save £40,000 in that account to earn enough interest to breach the savings allowance. Of course, a cash ISA could make more sense if interest rates rise.
These accounts are nowhere near keeping pace with inflation, currently at 6.2% (February 2022). If you want to try and maintain your money’s purchasing power, you could use a stocks and shares ISA tax wrapper (see below) but invest in one of the cautiously run multi-asset funds and investment trusts with a focus on capital preservation, such as Capital Gearing (LSE:CGT) investment trust or Troy Trojan fund.
2) Saving for long-term goals
This is an easy one: if you’re building a pot either for a specific goal decades down the line, or as a general long-term investment that you can access as and when you need it, or as a supplementary source of pension income, investing in the stock market via a stocks & shares ISA makes sense.
Although markets can be volatile in the short term, over the long term they outpace bonds and cash accounts. According to the latest Credit Suisse Global Investment Returns yearbook, global equities have produced an annualised real return of 5.3% over the last 122 years. In contrast, corporate bonds have returned an annualised 2% and US treasury bills 0.7%.
You can invest up to £20,000 in ISA accounts this tax year, and that can be split across different types of ISA. Stocks & shares ISAs such as that offered by interactive investor can be used to invest in equities, funds, investment trusts and exchange-traded funds (ETFs).
Although with an ISA you invest money that you’ve already paid tax on, it grows free of charge and when you withdraw cash there’s no further income or capital gains tax to pay, so what you see is what you get. This makes it very useful as a tax-free source of retirement income that will supplement your pension without boosting your tax bill.
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3) Saving for school fees
School fees are unusual as a savings goal, in that you know when they’re going to be payable and that they’re going to be hefty.
A recent Institute for Fiscal Studies report found the average private secondary school fee (not including boarding schools) was £13,700 per year. Fees have risen by 3.9% a year over the past decade.
That kind of outlay is much easier if you’ve started saving early. Close Brothers gives the example of a couple with a three-year-old whom they want to send to private secondary school.
“If the couple was to save £10,000 per year and they were able to generate a return of 6% per year on average on their savings, they could potentially amass a savings pot of around £100,000 by the time the child was ready to start secondary school.”
Clearly, it’s sensible to take tax out of the equation. A stocks & shares ISA with a regular savings facility is ideal. And there are no limitations to access, so you can continue to invest into it through the school years, while also drawing fee payments out.
4) Saving for your child’s future
Caught between a cost-of-living crisis and market turbulence, it may not feel like the obvious time to set up a regular savings scheme for your child’s future. But as with any long-term investment goal, the earlier you’re able to start, the longer your money has to grow.
are the obvious choice of tax wrapper. You can pay in up to £9,000 a year and choose between a cash or stocks and shares JISA. Either way, the money grows tax-free and there’s no tax to pay when it’s eventually accessed by the child (at age 16 for a cash JISA or 18 for the stocks and shares version).
However, as Myron Jobson, senior personal finance analyst at interactive investor, comments, with that kind of timescale it makes sense to opt for the potentially higher returns of the stock market-based option.
“Cash Junior ISAs are frankly pointless other than as an option for teenagers approaching adulthood who might shortly need to use their pot and therefore want to remove the short-term risk of a sudden loss of value,” he says. “Most Junior ISAs are going to be inherently very long term, because they cannot be accessed until the child is 18, so there is ample time for short-term bumps in stock markets to be ironed out.”
It’s an obvious scenario in which more future-facing investments make perfect sense, whether those have an environmental, social, governance (ESG) or climate-change focus, or are tapping into the potential of emerging markets or new technologies likely to be shaping the world of the next generation.
5) Saving for long-term retirement
The government has muddied the waters with the introduction of the Lifetime ISA (marketed as a solution for first-time buyers or retirement savers), but if you’re focused on saving for your retirement some decades down the line, a pension is generally much the best choice.
That’s because not only do you get full tax relief on the money you put in, but if it’s a workplace pension your employer will also contribute. The minimum contribution into a workplace scheme is a total 8% of your gross salary, of which the employer must pay at least 3%, but many employers are more generous. It amounts to free money going into your retirement pot.
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Even if you are paying into a personal pension or SIPP rather than signing up to the workplace scheme, your employer may be willing to make contributions, so do ask.
The price payable for generous upfront tax relief is that you cannot access your money until you’re at least 55. But inaccessibility makes the whole process easier and more effective for dedicated retirement saving. Once your pension is up and running, your investments can grow and compound over decades.
6) Saving to beat inflation
Inflation has been an increasing source of anxiety for people approaching retirement, as their capacity to save is being squeezed by rising living costs just as their pension pots have taken a hit during recent market volatility.
As Becky O’Connor, head of pensions at interactive investor, points out, the tax relief perk on pensions could come into its own in this context, as it provides an upfront boost to the value of contributions.
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She explains: “For basic-rate taxpayers, contributions get an instant 20% boost in the form of tax relief, so an £80 contribution becomes £100. For higher-rate taxpayers, contributions get 40% tax relief, so a £60 contribution becomes £100.
“There is no other tax benefit on an investment vehicle available to the masses that will instantly give you a protective buffer against inflation like this.” She suggests that any spare cash you can muster should be channelled into your pension as an inflation-beating measure for the coming years.
7) Saving for a non-taxpayer
Even without employer contributions, pensions are generally agreed to be the most generous tax wrapper, simply because the tax relief is provided when you first make your contribution, so the whole lot is invested, grows and produces returns that are reinvested and themselves generate returns – a key investment principle known as compounding.
But even if you’re not working (or earning under the annual personal allowance, currently £12,750, and therefore not paying income tax), you can still have a stakeholder pension (a simple personal pension plan with a limited choice of funds) and benefit from 20% tax relief on your contributions.
In this case, the most you can pay into your pension is £3,600, made up of your contributions of £2,880 and the taxman's contribution of £720.
This scenario might be relevant to individuals who are not working but have spare money, or to single-income couples where the earning partner sets up a pension for the non-earner and pays into it on their behalf.
8) Investing if you’re worried about breaching the pension lifetime allowance
Pensions, as we’ve seen, are a great way to save for the long term, but there is a limit, known as the lifetime allowance (LTA), to how much you can accumulate in a pension over the years without incurring a swingeing tax penalty.
The LTA currently stands at £1,073,100. That may sound like a huge amount, but over the decades higher earners may well be in danger of exceeding it. Jon Greer, head of retirement policy at Quilter, says that this could include those with pension pots now only half the value of the LTA and 15 or 20 years to go until retirement.
Greer gives the example of someone with a pension of £555,300 growing at 5% a year: even without further contributions from employer or employee, it would breach the LTA in 20 years’ time (assuming increases in line with inflation after 2026).
If you are worried you might find yourself in a similar position, you’re perhaps reluctant to keep piling money into your pension at this stage. In which case, what tax-efficient alternatives could you consider?
One option is to use venture capital trusts or VCTs. These are a type of specialist investment trust investing mainly in small companies, either unquoted or listed on the Alternative Investment Market (AIM). That’s a high-risk part of the market, so investors are compensated with generous tax breaks.
These include 30% income tax relief on investments in new VCT shares up to the value of £200,000 per tax year (dependent on the amount of income tax paid in the year the shares are bought), tax-free dividends and no capital gains tax on profits when the shares are sold.
Like pensions, these are long-term investments: to keep the 30% income tax relief, the shares have to be held for at least five years. But if you’re an experienced investor looking for pension alternatives and comfortable with the risks attached to start-up companies, it’s worth exploring the various types of VCT.
9) Investing to reduce inheritance tax
One problem for wealthier investors is that their ISA will count as part of their estate when they die, and inheritance tax (IHT) could therefore potentially be payable on it.
One way to get around this is to use it to hold a portfolio of AIM shares. Most AIM shares qualify for something called business property relief (BPR), which means that after two years of ownership they become exempt from IHT, although you must still own them at death to benefit. (The ones that don’t qualify for BPR are typically finance companies and property companies.)
In the meantime, of course, these investments have the potential to grow, with returns sheltered by the ISA from capital gains or income tax. But again they come with a health warning: companies listed on AIM tend to be higher risk than those on the mainstream market.
You could build your own ISA portfolio of qualifying AIM shares, or alternatively there are wealth managers running professionally managed portfolios of shares that benefit from IHT relief.
10) Investing for social impact
If you’d like to know that your investment is improving the world, and that is a priority for you above maximising returns, there is a tax incentive to encourage you to put your money where your good intentions are.
Social Investment Tax Relief (SITR) is a for individuals making an investment into an eligible charity or social enterprise - they come in many shapes and sizes. If you invest or make a loan under SITR, then provided you hold your investment for at least three years, you get income tax relief up to 30% of the amount you invest. So, for example, if you lend £1,000 to a social enterprise, the real cost to you is only £700.
In addition, capital gains when you sell your holding are tax-free; and you can also defer tax on capital gains from another investment by rolling the money over into a SITR-qualifying investment.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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