Investing through a tax-efficient wrapper, such as an individual savings account (Isa), pension, venture capital trust (VCT) or enterprise investment scheme (EIS), can give a significant boost to an overall investment portfolio, but they have to be blended with an appropriate investment strategy to give the best outcome.
There is a danger, moreover, of letting the tax tail wag the investment dog - so if you're going to look to some of the racier tax-avoidance schemes, you need to be sure that you are prepared for a more volatile ride.
PENSIONS AND ISAS
Isas and pensions will usually be the first tax wrappers you use to build your investment portfolio.
Isas offer huge investment flexibility, and all income and capital gains on investments within them are free from further tax.
For higher-rate and top-rate taxpayers, income tax rates of 40 and 45 per cent respectively are much higher than those for capital gains tax (CGT) at 18 and 28 per cent, so it can make more sense to prioritise income-generating shares and other income-producing investments such as equity income or bond funds for an Isa. In this way, it's possible to generate a long-term, tax-free income stream, which will be particularly useful in retirement, when income becomes a priority.
However it is worth reinvesting dividends in the early stages of building up your Isa portfolio when you're likely still to be working, as the effects of compounding can be very beneficial.
Income from a pension, in contrast to that from Isas, is taxable, but the key advantage is that investors get tax relief on their initial contribution at their highest marginal rate, up to an annual limit of £40,000 - at a time when they are more likely to be higher-rate taxpayers. The lifetime allowance (before HMRC claw back tax advantages) is £1.25 million, although from April 2016 this will fall to £1 million.
A further attraction to pensions is that they are very long term as they cannot be accessed before the age of 55; and, like Isas, all income and capital gains are free from tax within them. This allows investors to take greater risks and therefore perhaps look at investment areas such as emerging markets or smaller companies, which are more volatile but may have higher growth characteristics over the very long term.
Self-invested personal pensions (Sipps) allow much greater investment flexibility than conventional pensions and investors can build a more diversified and personalised portfolio (whether running it themselves or paying an adviser to do so). In some respects they also have more flexibility than Isas in terms of content - for example, Sipps can hold sterling bonds with less than five years to maturity, while Isas cannot.
For those interested in investing in some of the UK's most dynamic and entrepreneurial small companies, there are some extremely tax-efficient options, chief among which are venture capital trusts.
However, the majority are inherently high risk. To retain maximum tax benefits VCTs must be held for at least five years. Income tax relief of 30 per cent is available on new issues of VCT shares.
Investors can put up to £200,000 a year in a VCT and receive income tax relief on the entire amount, although they cannot receive more in rebates than has been paid in income tax.
When holdings are eventually sold, any gains made are free from CGT. Any dividends received are also free from tax.
There are three main types of VCT: limited life, specialist and generalist. Limited life VCTs tend to be lower risk, looking for an exit within, say, five years. Specialist VCTs focus on just one sector, often technology. Generalist VCTs will invest across a variety of businesses, often relatively well-established; in some cases they pay attractive dividends.
Performance has been mixed, with some VCTs providing good returns to investors over and above the income tax incentives, and some still losing money in spite of generous reliefs.
A company can only receive a total of £15 million of investment money from a VCT, though that rises to £20 million for 'knowledge-intensive' companies.
If you want to invest in a VCT please consider Interactive Investor, our sister site and award winning brokerage.
The tax reliefs available on an EIS are even more generous than those on a VCT. EIS invest in very small, start-up style companies, so they are also high risk. The tax relief on an initial investment into an EIS is also 30 per cent but investors can put in between £500 and £1 million, potentially getting rid of their entire income tax liability for a year.
There is also the potential to defer capital gains made on a separate investment by reinvesting them into an EIS. The reinvestment has to meet certain criteria - disposal of the original asset has to be less than 12 months before the EIS investment or less than 36 months after it.
In this way, gains can be deferred until a tax year in which you are not using your CGT allowance, or have retired and are paying lower tax rates anyway.
For the EIS investment itself, no CGT is payable if you sell the shares after three years, provided the EIS initial income tax relief was given and not withdrawn on those shares. Any losses on EIS shares can be set against your capital gains or income tax liability in the year of disposal.
The companies eligible for EIS must have gross assets of less than £15 million, and individual investors can have up to a 30 per cent stake in the business, so these schemes are not for widows and orphans. However, the tax breaks mitigate some of the risks.
Both VCTs and EISs can only invest in companies less than 12 years old, unless the investment will lead to 'a substantial change in the company's activity'.
The seed enterprise investment scheme (SEIS) is a version of EIS, offering an even bigger tax break on very small start-up businesses. Launched in 2012, SEIS give tax breaks to individuals investing up to £100,000 in qualifying companies.
By committing cash to an SEIS for three years, the investor benefits from a 50 per cent income tax break, CGT relief and capital gains loss relief.
We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.