When it comes to tax-efficient investing, pensions have long been a top priority for many people. Pensions can offer investors access to a wide range of investment choices, including funds that invest in the shares or bonds of leading global companies. They provide tax relief on contributions at the investor’s marginal rate, which have made them particularly appealing to those subject to the higher rates of income tax. Once invested, returns within pensions are free of both income and capital gains tax. And with the abolition of the pensions ‘death tax’, they can also be very effective for passing wealth on to the next generation.
But pension tax relief is being rationed down
While many have enjoyed greater choice and flexibility over how they can access their pensions, there has been a sting in the tail for some. As the Government has sought to get a grip on the deficit, the ‘cost’ of pensions tax relief to the Exchequer has been targeted and the amount of relief available increasingly rationed. This has happened through reductions to both the amount that can be contributed into pensions each year and the Lifetime Allowance (the amount that can be built-up in pensions, over and above which a punitive 55% tax is applied at the point pension benefits are taken).
The 2016/17 tax year has seen further noose tightening on pension tax relief. There has been a further reduction in the Lifetime Allowance from £1.25 million to £1 million. The Government has also introduced a new tapered annual pension allowance for higher earners. This latter development means that since 6 April 2016, individuals with taxable income greater than £150,000 have had their annual pension allowance reduced by £1 for every £2 they earn over £150,000, with a maximum reduction of £30,000. For those earning £210,000 or more this effectively means that they will only receive an annual pension allowance of £10,000 rather than the £40,000 available in the previous tax year. That’s irrespective of the amount they have previously invested in their pensions, or indeed whether they have any pension savings at all. Significantly, the £150,000 threshold for the new regime is defined as ‘adjusted income’, which includes not just salary and bonuses but also any company pension contributions and other benefits such as medical insurance, as well as investment income. Tapering has the potential to impact many professionals.
The impact of the new tapered allowance and the much reduced Lifetime Allowance means that more people are going to have to look beyond pensions for ways to save tax efficiently. Individual Savings Accounts (ISA) are of course a core choice and likely to be used by many affluent or higher-earning individuals, offering a combination of tax free returns, a wide choice of investments and flexibility. An increase in the annual ISA allowance from the current level of £15,240 to £20,000 from 6 April 2017 is good news, but it won’t make up for the potential shortfall facing many who will have seen their pension allowances dramatically eroded by the new tapered allowance.
Areas that are expected to garner more interest against this backdrop include more niche tax-efficient schemes such as Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS). Both of these are long-established schemes, enshrined in legislation, that are designed to encourage investment into small, UK businesses unquoted or traded on AIM (the London Stock Exchange’s junior market for growth companies). Companies backed by these schemes must meet other detailed criteria around their size, activities and age, and the funds must be used for development and growth. While these types of companies provide the potential for high returns, not all will succeed and they are illiquid investments, so the Government provides tax incentives for investors because of the inherently high risks involved. EIS is a scheme to facilitate direct ownership in the shares of such businesses, although there are also funds of EIS’s, whereas VCTs are investment companies listed on the London Stock Exchange. VCTs and EIS funds therefore provide investors with access to a diversified portfolio of such businesses selected by an investment team.
Investment into a new VCT share offer can provide subscribers with a 30% Income Tax credit. With an annual VCT allowance of up to £200,000, that means an investor could potentially receive up to £60,000 relief off their income tax liability, providing they are liable for the amount of income tax in the first place. Importantly though, once invested the VCT shares must be held for a minimum period of five years or the Income Tax credit will have to be repaid. Any dividends or gains on the VCT shares are tax-free.
Previous pension reductions have coincided with increased VCT demand
Previous reductions in the pension allowances have coincided with growth in new VCT fund raising. According to the Association of Investment Companies, £457.5 million of new funds were raised by VCTs in the 2015/16 tax year. That’s a 70% increase over the £267 million raised five years earlier in 2011/12. Over this period the pensions Lifetime Allowance reduced from £1.8 million to £1.25 million. There are therefore good grounds to expect continued growth in demand for VCTs, with the latest reduction in the Lifetime Allowance and new tapering regime.
Of course it is vital to look beyond the tax benefits and understand that these are provided for a reason: to encourage investment into illiquid companies that are much higher risk than well established, large, listed business. VCTs are therefore certainly not going to be suitable for all investors and should only be considered by those who understand and accept the risks involved, are prepared to invest for a minimum of five years (but potentially much longer) and who will benefit from the tax credits. VCT investors will typically be higher or additional-rate taxpayers who are already fully utilising pensions and ISAs. The specialist nature of VCTs means that they should not be considered as a like-for-like alternative to a mainstream investment scheme such as a pension or ISA portfolio. They can however be a valuable component to a diversified investment portfolio. It is of course important to choose VCTs carefully as the range of approaches differs, as does the experience and success rate of management teams.
For more information download our free VCT guide or visit our VCT pages here.