Business

How you can make tax efficient investments

To be particularly tax savvy, you could ask you employer to make a pension contribution as a salary sacrifice
Peter McGahan

A GOOD way to give tax a meaning, is to think of its impact on you. A 20 per cent inefficiency is the equivalent of eight hours in a 40-hour week. So, if your investments grew and paid just 20 per cent tax as they did so, that's the equivalent of one whole day of a working week, wasted solely for the tax man's benefit.

If they grew tax free, that's the equivalent of doing the same work but taking the Friday off. The compounding impact of tax is quite catastrophic.

Let's just assume an investment return of 8 per cent over 20 years on £100,000. Of course, you can work out the impact on you based on your investment portfolio size. With tax free growth, the portfolio would have returned a healthy £492,680.

But with the drain of tax at 20 per cent as it was growing, the final fund would be £358,442, a staggering £134,238 difference.

Choosing the best portfolio is one thing, but ensuring there are no restrictive drags like tax, or excessive management charges is clearly key to ensuring your money gives you the best options later in life.

Once you have chosen your investment portfolio with your adviser, your adviser will be recommending the most tax efficient place for them to grow.

The same portfolio can be placed into a pension, ISA, range unit trusts/ OEICS, or investment bond. I've excluded other tax efficient schemes like venture capital trusts and enterprise investment schemes here as they are restricted in terms of the choice of investment portfolio.

A pension and ISA are the most tax efficient ways to invest for sure. A pension is naturally the first choice given its tax breaks. Each contribution immediately attracts tax relief on the premium so a basic rate tax payer putting in £10,000 enjoys an uplift at 25 per cent to £12,500.

To be even more tax savvy, you could ask you employer to make the contribution as a salary sacrifice. You simply forego the part of your salary that you want to make as a pension contribution and this saves you and your employer national insurance on that contribution. The employer could also use their national insurance saving and pay into your pension.

This is a ‘quadruple whammy' of tax relief on the premium, double national insurance saving and tax free growth on the pension.

Before you think of making mass contributions, unfortunately, if you do pay tax in the UK, the basic rule is that you can only receive tax relief on a pension contribution up to 100 per cent of your earnings, or a £40,000 annual allowance whichever is the lower.

However, in a slight bend to that rule, a non-taxpayer can pay £2,880 into a pension and have an immediate uplift to £3,600.

Next on the tax efficiency list is the ISA. Here you have an annual allowance of just £20,000. You pay no income tax on interest or dividends, and on encashment, all investments are free of capital gains tax.

After that, it starts to need more calculation as to the next most tax efficient wrapper to wrap around your portfolio.

Unit trusts/ OEICS are arguably the next most efficient. Interest distributions from UK domiciled funds are paid gross, and if you receive income via dividends in the above funds, these are also paid gross. From April 2018, a new tax-free dividend allowance of £2,000 per year was introduced.

When you decide to encash or take profits from unit trusts/ OEICS, the gain is assessed as a ‘capital gain'. Fortunately, you have an annual capital gains allowance of £12,000 for you and your spouse.

All gains within that are free of tax. A good Independent Financial Adviser will turn your portfolio around regularly to use up your capital gains tax each year, meaning that on final encashment, the Gain is much less.

The capital gains is assessed at 10 per cent for a basic rate tax payer, and 20 per cent for a higher rate tax taxpayer.

An investment bond is next, where all gains and income earned within the bond are taxed at 20 per cent.

:: Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a question on investments, call Darren McKeever on 028 6863 2692, email info@wwfp.net or visit on www.wwfp.net.

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