Tax Efficient Investments
Tax-efficient investments include Individual Savings Accounts (ISA), Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS). ISAs provide relief from income and capital gains tax. VCTs and EIS schemes provide tax relief on the contributions as well as other tax benefits. They are a potentially important part of the overall financial plan, and complement savings into pensions.
To contribute to an ISA, you must be resident in the UK, or a non-resident Crown employee working overseas. If you are resident overseas, you can keep any ISAs you have, but not add to them. The contribution limits are currently £10,200 per year, of which up to £5,100 can be invested in the cash component. The contribution limit will increase in line with RPI inflation from April 2011.
The stocks-and-shares portion can be invested in almost anything other than cash, so it can include gilts, provided they have at least 5 years to redemption when bought. On 6 April 2008 PEPs were merged with ISAs. It is possible to transfer a cash ISA to the stocks-and-shares component, which is proving popular at the moment because the interest rate on cash is low, and there are better opportunities in fixed interest investments and equities. If you contribute to an ISA every year, you can build up a fund that can provide tax-free income in retirement, to add to your pension. It usually makes sense to put the fixed interest component of your portfolio into an ISA, so that the interest accumulates tax-free. The more growth-oriented investments in your portfolio can sit outside the ISA, giving you the chance to take advantage of the capital gains tax allowance, which is currently £10,100 for individuals and estates (half that for trusts).
VCTs offer 30% income tax relief on the contributions to buy new shares up to £200,000 in a tax year. You have to hold the shares for at least 5 years to keep the tax relief. The VCT itself has 3 years in which to invest 70% of the funds in qualifying investments. The dividends are free of income tax, but the tax credit cannot be reclaimed, which is the same as for ISAs and pensions. VCTs tend to pay very good dividends, because this is the main way in which they reward the investor. Indeed, the longer term returns of some of the established VCTs such as Baronsmead and Proven have been very good. Downing Protected Opportunities has the stated objective of providing tax-free dividends of 7.1%. Framlington AIM VCT currently pays a dividend of 20.6%! The shares can be sold in the secondary market, but they tend to trade at a discount to net asset value. For example, the Baronsmead VCT is currently trading at a discount of 11.0%. Information on VCTs available in the secondary market can be found on Trustnet (www.trustnet.com) . They can be bought without the initial tax relief, but with the tax relief on income and capital gains. They provide a useful addition to pension savings, because of the additional tax benefits, and the recent budget changes are likely to make VCTs particularly attractive for people with incomes over £100,000.
EIS offer 20% income tax relief on the contributions of up to £500,000 in a tax year. Relief is given as a tax credit against your income tax liability, and this is lost if the shares are sold within three years. It is possible to carry back some of the tax relief to the previous tax year. The main attraction of EIS, however, is the ability to defer capital gains tax, and after two years the holding will qualify for 100% business property relief from inheritance tax (IHT). To defer capital gains tax, you must buy the EIS within 3 years after the gain was realized, or one year before. When the EIS is sold, the deferred capital gain becomes taxable. Any gain realized from the EIS investments is tax free, and if there has been a loss, it can be offset against other income or capital gains. You can defer a capital gain indefinitely by keeping an EIS until death, at which point it will no longer be taxable, and nor will the EIS be included for inheritance tax. The problem is the risk of investing in the sort of unlisted investments that qualify for EIS and VCT. There are, nevertheless, some lower risk or protected versions available in the market. Smaller companies are more sensitive to economic changes than large companies, but their share prices tend to increase more rapidly when the markets recover.