If you’re a higher or additional rate taxpayer paying tax at 40% or 45%, you’ll want to do everything you can to reduce the amount you have to hand over to the taxman.
You will be pleased to know there are plenty of tax-efficient investments available which enable you to keep tax bills to a minimum. However, many of them are risky, so it’s vital you seek professional financial advice to ensure that you understand how they work and whether they are right for you.
Pensions have always been one of the most tax-efficient ways to save for the future, although recent changes have made them less appealing for additional rate taxpayers.
To spur people on to save towards retirement, the government automatically gives tax relief of 20% on any pension contributions you make. If you’re a higher or top-rate taxpayer, you can reclaim an extra 20% or 25% through your self-assessment tax return.
That means a £10,000 pension contribution can cost you just £6,000 if you’re a higher rate taxpayer, or £5,500 if you’re a top rate taxpayer.
However, there’s a maximum £60,000 annual allowance which applies your pension contributions each tax year. You won’t receive rate relief on any contributions you make over the £60,000 threshold.
Under changes announced by the government, pension tax relief is progressively reduced for those earning £150,000 or more. From April 2023, it will be reduced at a rate of £1 for every £2 earned over £260,000 to a minimum of £10,000. This means that the tax allowance for those earning over £260,000 putting money into pensions will be cut to £10,000.
This tapering of tax relief on pensions may mean that high earners may be better off exploring alternative tax-efficient investments such as those outlined below.
Individual savings accounts (ISAs) are a form of tax-free savings account wherein returns are free from income tax and capital gains tax.
In the 2023/24 tax year, you can invest up to £20,000 into ISAs, either into stocks and shares, or into cash, or a combination of the two. Cash ISAs tend to suit those who are very risk averse, or who are only investing over a very short time-frame.
Those who are investing over the long term, and who are prepared to accept a level of risk for the potential for higher returns, should look to build a balanced portfolio of stocks and shares investments.
An adviser will be able to recommend the right mix of investment to suit your risk profile and investment objectives. You can either invest in individual funds directly with a fund manager or managers, or you can use a fund supermarket to mix a wide range of funds within a single ISA.
A Venture Capital Trust (VCT) is a company which invests in very small, fledgling companies and whose shares are traded on the stock market. They aren’t for the faint-hearted as the companies invested in are only just getting going, and not all of them will succeed, so you may get back less than you invested.
VCT shares can also be hard to sell, so you may not be able to liquidate them quickly if you need ready capital to hand.
There are significant tax benefits offered to VCT investors, with income tax relief given at 30% on annual contributions of up to £200,000. That means, for example, that if you invest £10,000, you’ll get £3,000 back from the taxman. You only get to keep this tax rebate if you hold your VCT shares for at least 5 years.
There is also no tax on gains, regardless of how long you hold the VCT, as well as no income tax to pay on dividends. This is likely to be particularly attractive to high earners given changes to the way dividends are taxed. These changes mean that from next year those receiving more than £2,000 in dividend income outside an ISA will pay more tax.
However, despite all the tax benefits of VCTs, they will only be suitable for a minority of investors due to the risks involved, so always get professional advice before you invest.
There are several tax incentives for higher rate taxpayers who invest in small, unquoted companies via an Enterprise Investment Scheme (EIS).
The EIS was launched in 1994, to encourage people to invest in small companies.
When you make your initial investment, which you usually make directly in a qualifying company, you receive income tax relief at 30% of the cost of the shares. For example, if you invest £10,000, you can reduce your income tax by £3,000 that year. You can also “carry back” this relief to help reduce your income tax liability in the previous year.
There’s also no capital gains tax to pay on any profits you make from an EIS investment. If your investment performs badly and you make a loss, you can offset that loss against income tax. You must hold EIS investments for a minimum of 3 years in order to qualify for this capital gains and income tax relief.
You will, however, have to pay tax on any dividends you receive.
The maximum amount you can invest in any one company is £1m, and there is no minimum. Investing in EISs usually requires you tying up your money for a long period of time, so they won’t suit you if you need access to your savings.
EIS investments are protected from inheritance tax providing you’ve held them for at least 2 years at the date of your death.
As with VCTs, an EIS is a high-risk investment that can be difficult to sell. It’s unlikely to be suitable for those with low risk appetite or those who may need ready access to their funds.
The Seed Enterprise Investment Scheme (SEIS) was introduced in 2012. It works in a similar way to EIS, except you invest in even smaller start-up companies. These are particularly high-risk, so investors are offered even more generous tax breaks.
You receive income tax relief at 50% rather than 30%, which means for every £10,000 you invest, you can deduct £5,000 off your income tax bill. There is no capital gains tax to pay and as with EIS, you can offset any losses against tax too.
There are other capital gains tax benefits too. If you’ve recently had to pay capital gains tax on other investment, you can reclaim up to 50% of this tax as long as you reinvest the money into SEIS.
The maximum you can invest though SEIS in any one tax year is £100,000.
These investments are even higher risk than VCTs and Enterprise Investment Schemes, so are only suitable for a minority of people. Discuss such investments with your adviser before going ahead and only after other forms of tax-efficient investments have been looked into.
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