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The art of tax efficient investing
Monday 5th April, 2021
The best way I can demonstrate the impact of effective tax planning is through a little theoretical exercise I do with my UK clients. The first thing I ask them is how much income can a married couple, both aged 65, earn in retirement before they have to pay tax? The standard answer is £25,140 based on two personal Income Tax allowances. This answer is understandable, but incorrect.
Firstly, they would indeed be entitled to take £25,140 of income, tax free, using their two personal allowances (£12,570 each). This personal income tax allowance would normally be used up by income generated from their personal pensions and state pension.
They can also jointly take £24,600 of capital gains from their investments each year by using their CGT allowances to offset any CGT they may be liable for. This means structuring their portfolio so that there are sufficient funds available to generate the necessary gains to utilise this allowance each year.
If they have both been using their ISA allowance each year, it is reasonable to assume that they each have at least £100,000 invested in tax efficient ISAs. As mentioned before, any withdrawals taken from ISAs are tax free and it is reasonable to expect a return on a Stocks and Shares ISA of 5% per annum, depending on the underlying investments. Therefore, the married couple could expect to generate a further £10,000 per year of tax-free income and withdrawals from the ISAs.
Therefore, with the correct financial planning, a married couple at age 65 could theoretically be able to earn £59,740 a year in income and withdrawals from their portfolio and pensions before becoming liable for any tax, if it has been properly structured, and all allowances used.
In addition to the above allowances, a married couple would also be able to receive £4,000 (£2,000 each) in dividends tax free, using their tax-free dividend allowances. This could potentially increase their tax-free income to £63,740. This will necessitate them having dividend generating investments.
If there were additional funds, we could look at investing into an Offshore Bond. For arguments sake, let us say that they have £200,000 available from the sale of a second property. This could be invested into an Offshore Bond for growth. They could withdraw 5% of the original capital each year, and this would be treated by HMRC as a return of capital. This would not need to be declared on a tax return and no tax would need to be paid on the withdrawals. These could be switched on and off at will and any unused 5% allowances simply accumulate and can be used in later years. They could withdraw £10,000 (5% of £200,000) per year for 20 years. This could be paid out to them in monthly, quarterly, or annual increments. This would take their net income up to £73,740 per annum.
As mentioned above, this is a theoretical exercise. However, it demonstrates very clearly the benefit of using all the allowances and tax efficient options that you have available. How many people do you know can have returns of £73,740 per year before they even begin paying the most basic level of tax?
There are also more niche options available to generate even more tax-free income such as Venture Capital Trusts (VCT). I have not gone into too much depth on this area, as these involve high levels of risk. They do provide an initial 30% tax relief on income tax, which provides some upside right from the beginning. They can also offer very high dividends, which are tax free and can provide a very nice supplementary income. However, these are also very illiquid and often sell at well below net asset value.
I have a client who had built up a large amount of cash, and was looking to invest the majority of it to provide an income to live off when he eventually retired. He was not keen to save into a pension, as his was already substantially in excess of the Lifetime Allowance. We therefore had to look at a number of none-pension investment vehicles. His main concern was that his investment income would result in him being a higher rate tax payer all through his retirement, which he wanted to avoid, if possible. We managed to invest all his investments into a portfolio of onshore unwrapped investments, an Offshore Investment Bond and ISAs over time. He does not currently draw down upon these, but rather lives off the income provided by a number of VCTs he built up using his bonuses from employment. Gains and dividend from the unwrapped investments have largely been offset against his allowances. Thanks to some good financial planning he is a non-taxpayer despite his considerable wealth.
It is important to note that when using tax vehicles like VCTs or Enterprise Investment Schemes (EIS), we are simply tweaking the tax efficiency of your main structure. Your main tax planning should still revolve around the main allowances mentioned initially.
At no point should the conversation ever veer into evading tax. The options discussed above are legitimate tax planning measures, which allows the shrewd investor to minimise the tax drag on their investment returns.
Many investors unfortunately participate in aggressive tax planning. In these cases, investors invest their money into schemes that are legal, but go against the spirit or intent of legislation. HMRC responds quite quickly to these and they are rapidly closed down. As a general rule, the only people who benefit from this type of scheme are the people who set it up. The investors themselves are left out of pocket, with substantial tax liabilities and without a leg to stand on.Tax evasion by actively hiding returns or not declaring them is illegal.