Tax Efficient Investments

Tax Efficient Investments - be aware of the Trojan Horse!!

The tendency of UK Governments in recent years has been towards encouraging taxpayers to save and invest. This has resulted in various ‘tax efficient’ products being made available.

When thinking about tax-efficient investments, for many people the first thing that comes to mind is an ISA (or Individual Savings Account), which replaced their predecessors PEPs and TESSAs.

An ISA is not an investment in its own right, it’s more of a tax-efficient wrapper in which you put your cash to protect it from personal income tax and capital gains tax.

There are two types of ISA:

  • Cash ISA
  • Stocks & Shares ISA

Each year your have an annual allowance of £7,200 that can be invested in ISA’s (£10,200 for those aged over 50).

A Cash ISA allows you to invest up to £3600 each tax year (£5,100 for those aged over 50). You can choose to invest all your allowance into a Stocks & Shares ISA. Alternatively you can choose to split your allowance across the two types provided you do not exceed the annual allowance. For example you may choose to invest only £2000 in a Cash ISA meaning you could invest £5200 in a Stocks & Shares ISA for the tax year.

The tax benefits are that you don’t pay tax on any interest you receive from your Cash ISA, and no tax is paid on Capital Gains arising from your investment dividends earned by Stocks and Shares ISAs.

WARNING! ISAs are not necessarily ‘Tax Efficient’

The tax efficiency of any investment needs to be carefully analysed from your own personal point of view and circumstance. Not all investments that appear to offer tax benefits and incentives will necessarily benefit you.

Don’t necessarily be seduced by the lure of being able to build assets under a ‘Tax Free’ umbrella. Many investors are aged over 70 and these are the ones which are at the greatest risk of losing out on the tax efficient benefits of their savings strategy. The reason for this is that assets within an ISA, PEP or TESSA portfolio, form part of the estate on death, and Inheritance Tax then applies if your estate is worth more than £325,000. This potentially means a 40% tax on these ‘tax free’ assets, and that is tax on the whole amount – the original capital plus all the growth.

Potentially this could be significantly more than the comparatively modest tax savings on the growth and/or income made during your lifetime via ISAs.

Investors who had PEP and ISAs recommended to them on grounds of their tax efficiency can mistakenly fall into the trap of thinking there are substantial tax benefits in retaining PEP and ISA portfolios, only to find that they will form part of their estate upon death. Holding these investments without considering wider issues simply ensures that the Revenue can collect large amounts of IHT from the unwitting and unprepared elderly investor.

While younger investors should take advantage of the benefits of ISAs to build up tax efficient funds, it doesn’t always make sense for older investors who may fall into the IHT trap.

If Inheritance Tax applies, other forms of investment could be considered as an alternative to ISAs. For example onshore or offshore investment bonds are liable to tax on their growth, but may be suitable for use in estate planning as these can be placed in Trust with a view to potentially avoiding Inheritance Tax.

Levels, bases of and reliefs from taxation may be subject to change. The Financial Services Authority does not regulate taxation and trust advice