David Prosser examines how you can make the most of tax-efficient savings.
As speculation mounts over the narrow room for manoeuvre Phillip Hammond has in this month’s Budget, savers and investors are growing anxious about where the Chancellor might raise money to fund some of the giveaways that the political situation now demands. But amid the pre-Budget advice about how to beat the Chancellor to the drop, it’s easy to lose sight of the basics of sound financial planning.
In particular, taking advantage of generous tax-free savings allowances is likely to net you a far greater long-term return than any clever short-term tactics. We are now just over half way through the tax year and it’s important not to leave it too late to take advantage of the allowances available.
For most people, that means starting with individual savings accounts. Remember, ISAs are not investments in their own right. Rather they are shelters within which you can hold a broad range of investments – the annual ISA allowance currently allows you to invest £20,000 through an ISA; you can put all the money into cash, all of it into investments such as stocks and shares or stock market funds, or a mixture. There is no income tax to pay on any income these investments generate, and no capital gains tax (CGT) to pay on profits.
Some people believe the attractions of ISAs have diminished in recent years. In 2016, the Chancellor introduced a dividend allowance, enabling people to receive up to £5,000 of dividend income from their investments tax-free. Also, everyone is entitled to a capital gains tax allowance – worth £11,300 this year – and investment profits below this cap in any one tax year are also tax-free.
Bear in mind, however, that most ISA wrappers are provided free by investment managers, so you’re not paying anything to use the shelter. From next April, moreover, the annual dividend allowance is reducing to £2,000, so that has the potential to catch more people out; and while £11,300 sounds a large sum, investment gains add up over the long term – getting them into tax-free shelters later on is likely to prove tricky.
If ISAs are a no-brainer, so too are pension allowances – with the one proviso that you must be prepared to tie your money up until you reach at least age 55.
While the Chancellor may tinker with the rules on private pensions in the budget, the system is currently very generous and is unlikely to change before next April at the earliest. In the 2017-18 financial year, most people are allowed to invest as much as they earn in a private pension, up to a maximum of £40,000 (though the figure is lower for those with incomes of more than £150,000).
Pension savings attract upfront tax relief at your marginal rate of tax. So paying £1,000 into a private pension costs a higher-rate taxpayer only £600 and a basic-rate taxpayer only £800. Thereafter, private pension investments grow free of both income and capital gains tax.
How to use your allowances
With less than six months of the tax year remaining, what’s the best way to use your ISA and pension allowances while you still can? Well, financial advisers increasingly make the case for the investment companies sector, with most closed-ended funds now available for purchase inside an ISA or pension plan.
There are several good reasons to consider investment companies for these shelters. Not least, their long-term performance record is superior to other types of investment fund. Although investors should not consider past performance to be a guide to the future, studies have repeatedly shown that investment companies have outperformed open-ended funds over periods of five years or more.
One attraction of investment companies is that with a fixed pool of assets to manage - unlike in an open-ended fund – the manager finds it easier to take a long-term view on investments. This works well in ISAs and pensions as their tax efficiency makes them a good wrapper in which to build up investments over the long term.
Gearing is another issue to consider. Investment companies, unlike other types of fund, are allowed to take on borrowing. When asset prices are rising, this borrowing acts as a multiplier on returns. And while the opposite is true when prices are falling, if you’re investing for the long term, gearing can deliver improved performance.
Finally, don’t despair if you don’t have the full £20,000 or £40,000 to invest in an ISA or private pension respectively. Most people don’t. Investment companies accept lump sum payments of as little as a few hundred pounds, or regular savings starting from £25 a month. You must be prepared to accept the risk of your investment falling in value as well as rising, but if you’re looking for a tax-efficient, long-term way to save, investment companies inside ISAs and pensions have lots going for them. The Chancellor is unlikely to meddle with that.