David Prosser looks at five ways to save and invest for the future as tax-efficiently as possible this year.
New year, new you? For many people, getting on top of their finances is an important New Year’s resolution – they are determined to finally begin saving and investing for the future. And the good news, if that’s you, is that the financial system is set up to encourage you to do exactly that. There are generous tax perks for people making responsible financial provisions – you’re effectively getting free cash from the State.
The important thing to remember about these benefits is that you should never make an investment simply in order to secure a tax break – it has to be appropriate to your circumstances, priorities and attitude to risk. But as you save and invest for the future, it makes sense to do so as tax-efficiently as possible. Here are five ways to do exactly that.
1. Use your individual savings account allowance
Individual savings accounts (ISAs) are like wrappers, protecting everything you hold within them from the taxman. Any income or profit you earn on an investment held within an ISA is completely free from tax – you don’t even need to declare it to HM Revenue & Customs. Nor is there any tax to pay when you take money out of an ISA.
All adults in the UK are entitled to a £20,000 ISA allowance in the 2021-22 tax year, which ends on April 5. Unused ISA allowance is gone for good, but you’ll get another £20,000 allowance for the 2022-23 tax year, beginning on April 6.
The rules on which savings and investments are permissible holdings for your ISA are very broad – you can even include cash savings. But if you’re investing for the long-term, it makes sense to focus on assets with the greatest potential to increase in value over the time, which usually means stock market investments.
In which case, investment companies could be ideal. These are collective funds run by professional managers who pool your money with contributions from other investors to buy a spread of different shares. Through online investment platforms, you can invest a small amount in investment trusts each month, which can be a good way to use your ISA allowance if you don’t have a large one-off sum.
2. Take advantage of private pension tax breaks
Private pensions are another type of tax-free wrapper. As with ISAs, the investments you hold within them build up free from tax. But in addition, you get tax relief on your private pension contributions – so it costs just £600 and £800 respectively for basic-rate and higher-rate taxpayers to make £1,000 worth of pension savings; the State makes up the difference.
You’re not allowed to cash in your pensions until later in life – currently, not until age 55, though that will soon increase to 57. And when you do start converting them to income, there is tax to pay, though you may take up to 25% of your savings as a tax-free lump sum. In the meantime, however, you’ve had the benefit of all that upfront tax relief.
As with ISAs, a broad range of investments can be held in private pensions, including investment companies, which offer long-term exposure to the stock market. For most people, the annual pension contribution allowance is £40,000 or their annual earnings – whichever is the lower figure.
3. Exploit your tax-free dividend allowance
If you need to take income from your investments – to top up your pension, for example – it makes sense to use assets held within ISAs since this income will be tax-free. But in addition, consider using your tax-free dividend allowance.
Currently, this entitles everyone to earn dividends from shares, including investment company shares, worth up to £2,000 a year before they have to pay any income tax on the money. This is in addition to the usual income tax allowances.
4. Check out venture capital trusts
Venture capital trusts (VCTs) are a specialist type of investment company that buy into small companies yet to list on the stock market. There are strict rules on which companies VCTs may put money into, but the scheme provides very generous tax benefits.
Investors in new VCT shares – as opposed to those trading on the stock market already – get upfront income tax relief at a rate of 30%, so putting £1,000 into a fund costs only £700. In addition, all capital gains on VCT shares are tax-free. So too is the dividend income that the funds pay.
These perks reflect the reality that the small companies that VCTs buy are at an early stage and yet to fully prove themselves – they are therefore more risky. But a professional VCT manager can help you manage this risk, and funds invest in a spread of qualifying businesses, which also offers protection.
Currently, investors can put up to £200,000 into VCTs each year – that is 10 times’ the ISA limit.
5. Think about your children
Putting money aside for children is a crucial priority for many people. And if you use certain schemes designed specifically for this purpose, it is possible to net further tax advantages.
For example, you can open a Junior ISA on behalf of a child under aged 18. As with adult ISAs, you use this wrapper to protect a very wide range of investments from tax on income and profits – including investment companies. The annual junior ISA allowance is currently £9,000.
You can even open a private pension on behalf of a child, with a maximum annual contribution of £3,600 (at a cost of £2,880 to you, taking into account tax relief). They won’t be able to get at the money until much later in life, but the pension can be invested in all the same assets as your own account.