Each tax wrapper has certain characteristics that make it more or less appropriate for different types of investment.
Isas and pensions
There are two main types of tax-incentivised investment: individual savings accounts and pensions, including self-invested personal pensions (Sipps). Between Isas and pensions alone, investors can tuck away over £50,000 a year, or £100,000 for a couple. If they have children, a further £3,720 for each child can be added through junior Isas, and another £3,600 a child through children’s pensions. Those willing to take on the higher risk of investment into new venture capital trust (VCT) issues can add another £200,000 to that total. In other words, investors can shelter significant amounts of their savings from tax without straying into any celebrity-style tax planning.
Each of these tax wrappers has different characteristics. From an investment perspective, the treatment of income and the accessibility of the assets within each wrapper are important.
Income: Within an Isa, interest earned on cash deposits and bonds is tax-free. Investors also have no further tax to pay on share dividends (though the 10 per cent ‘tax credit’ deducted at source cannot be reclaimed). This is an advantage for higher-rate taxpayers, who would otherwise have to pay additional tax on their income stream.
Equally, the income from Isas does not count towards the age-related tax allowance for people over 65. Also, Isa income does not have to be declared on a tax return. Perhaps most importantly, it can be taken at any time and in perpetuity. Investors do not have to reach a certain age to access it, and nor do they need to shift their Isa into alternative products at a certain point, as they would with a pension.
Pensions work slightly differently. All income rolled up within a pension is tax-free. Investors pay no further tax on dividends and receive bond coupons gross, but they cannot take an income from the fund until they are 55 or over. When they do, they have to take it via an annuity or a drawdown scheme; in both cases there are certain restrictions and the income is taxable. This makes it less appropriate for, for example, school fees planning or more immediate income needs.
Capital gains: Capital gains are treated the same for both pensions and Isas – they are entirely tax-free. Again, investors cannot withdraw any cash from pensions until they are 55. This forces them to take a long-term view and means they don’t require as much liquidity from their investments, certainly not in the early years. This is important – liquidity comes at a premium, and investors willing to invest in less liquid assets are therefore at an advantage. In contrast, capital from Isas can be taken at any time, so they suit more liquid assets.
Venture capital trusts
The tax breaks available on investment in new VCTs are generous. Investors can get 30 per cent income tax relief on contributions of up to £200,000. They must then hold the shares for at least five years. All VCTs, whether new issues or those bought in the secondary market, have no income tax on the dividends and no capital gains tax (CGT) on any growth in the shares.
In return, the investment remit of VCTs is significantly restricted. Underlying companies must not exceed a certain turnover and size, and are generally early-stage. This means that they are a higher-risk investment. However, Mark Dampier, head of research at Hargreaves Lansdown, says the sector has improved considerably as weaker trusts have wound down. Certainly more experienced managers such as Northern Venture Managers or Unicorn have delivered some strong performance.
Equally, there is still plenty of choice in the sector. Trust managers will often specialise in one particular area: Alternative Investment Market (Aim) stocks, for example, or technology. Investors can be nuanced about the risks they are taking with VCTs. However, it goes without saying that VCTs must be considered a long-term investment, not least because the tax advantages disappear if investors withdraw their cash too soon. However, although the risk profile of the trusts would suggest that they are pure growth investments, Dampier says that many investors who have already used their pension and Isa allowances are now using VCTs as a secondary source of tax-free income alongside Isas.
Pensions are above all a wrapper that fits a long-term investment strategy. Investors get all those juicy tax advantages up front, but need to take a ‘jam tomorrow’ approach because they can’t receive any benefits from a pension until they are 55 or older. Counter-intuitively, this means investors can take more risk in a pension.
This may involve focusing on areas that are more volatile – emerging markets, private equity, smaller companies – but likely to deliver higher growth over the long term. It also means investors have to take greater account of inflation. Over a couple of years, inflation is unlikely to make a significant dent in investment returns, but over 30 years it will. So it’s important to ensure a portfolio has sufficient exposure to inflation-sensitive assets, such as equities, commodities or inflation-linked bonds.
Of course, a long-term perspective does not rule out holding income-generative assets in a pension. Dampier adds that the compounding effect of dividends reinvested into a portfolio is powerful and should not be neglected. Equally, as investors approach retirement, their pension is still likely to be their single biggest source of future income and therefore they will need to switch into some higher-income, lower-risk assets.
With Isas, income and capital can be withdrawn at any time, free of tax. This allows for considerable flexibility and therefore generally suits more liquid assets, unless investors are very disciplined and are certain they will not need the capital from their Isa. The likelihood of a shorter-term time horizon means some of the more esoteric and illiquid asset classes open to pension investors may not be appropriate for an Isa.
Isas are at their most valuable when generating a long-term income stream. A portfolio of equity income funds, for example, can create an inflation-protected income stream that can be used immediately. The same is true for corporate and government bonds. Although the yields available on fixed income are currently poor because interest rates are so low, this will not always be the case.
Adrian Lowcock, senior investment manager at Hargreaves Lansdown, points out the differences between various income-generative assets in an Isa. ‘If you’re taking an income, bonds have some distinct advantages. The income is received completely tax-free at source and so offers a tax-free income. Dividends from shares are received net of 10 per cent dividend tax credit, but have the advantage that the dividend could grow (though conversely it may fall).
‘Additionally, when looking for an income, it is critical to remember the effects of inflation: over 25.1 years, inflation at the current Consumer Prices Index rate of 2.8 per cent will halve spending power.’ Lowcock concludes that a mix of corporate bonds and equity income is essential to ensure that a portfolio is sufficiently diversified to produce enough income over the long term.
Strategies for investors
Those investors who may not want to take asset allocation decisions themselves could look to an income-generative multi-asset fund for their Isa, whether as an active, passive or blended portfolio. They could then look to a more capital-growth focused multi-asset fund for their pension. In both cases minimising drawdown and maximising the effect of long-term compounding should be a priority. The danger for this type of investor may be insufficient inflation protection and over-exposure to fixed income.
Medium-risk investors should seek a balance of income-generative assets within an Isa, incorporating both equity income and some fixed-income exposure. They can then place higher-risk assets, such as emerging market or commodities funds, in their pension as part of a wider balanced equity-focused portfolio in the early years, shifting towards lower-risk assets over time.
More experienced investors can introduce more esoteric income strategies into their Isa – either less liquid parts of the fixed-income market, or areas such as emerging markets income. They may also wish to use their Sipp flexibility to its maximum, perhaps incorporating commercial property; or could perhaps dip a toe into venture capital trusts.