Use it or lose it
You may not trust the Chancellor, says Ian Cowie, but you should take advantage of the tax breaks he offers The more ways Gordon Brown finds to tax us in his budgets, the less many of us seem inclined to take full advantage of the tax breaks he still offers us on our savings. Why bother with pensions, individual savings accounts (Isas) or any of the other tax-efficient investments so eagerly promoted by financial advisers especially when you consider the rotten returns delivered by some of these products — after a combination of high charges and low investment performance?
Fortunately, investors today stand to benefit from rising stock markets and falling costs. The FTSE 100 index has risen by more than 75 per cent since its low point in March 2003, and many smaller companies have done better than that.
At the same time, competition between fund managers, combined with regulatory intervention, has driven costs down. Stakeholder pensions have no initial charges — unlike traditional personal pensions where the contributions you paid in the first year or more might merely fund the salesman’s commission — and the maximum annual charge is 1.5 per cent for stakeholder pensions sold since April last year.
Most of the rules governing all types of pensions will change on 6 April (‘A-Day’), but the fundamental attraction remains the same. Payments into pensions can attract initial tax relief equal to the individual saver’s top rate of income tax. So it costs most people £780 to boost the value of their pension fund by £1,000 before costs; high-earners can achieve the same effect at a net cost of £600. Non-taxpayers, including children, can invest — or have invested on their behalf — up to £2,808 per annum in a stakeholder pension, and HM Revenue & Customs will gross that up to £3,600.
The downside is that they cannot touch the money before they reach the age of 50, and this will rise to 55 in 2010. Even after that there will be restrictions, with no more than 25 per cent of the fund able to be drawn out as tax-free cash. However, the new rules which come into effect on A-Day will ease some of these restrictions, and have the immediate effect of removing much of the marketing pressure to invest in pensions before the end of the fiscal year on 5 April. The current complex rules which define maximum annual pension contributions in relation to the individual’s age and earnings will be replaced by a limit of £215,000, or 100 per cent of the individual’s earnings. For most people this represents a substantial increase in their access to the pensions tax shelter.
Anyone who is cynical about the marketing of tax-favoured investments should consider the alternative. The Budget usually goes a long way towards illustrating these investments’ value by reminding us how much tax we are going to pay, unless we do something about it. Bearing in mind that the vast majority of people invest out of earnings that have already suffered income tax, most taxes on savings and investments can be regarded as double taxation.
Put more positively, a tax-free wrapper can boost the cash-in-hand return on some assets by a quarter for basic-rate taxpayers and by two thirds for high-earners. At its simplest, instead of settling for bank or building society returns of, say, £80, most savers could raise this to £100 by the simple expedient of holding their deposit in an Isa. For savers subject to 40 per cent income tax, the net interest on the same deposit outside an Isa would be just £60 as opposed to £100 inside the Isa.
There is no need to increase the risks you take in order to receive tax-free returns from an Isa; nor is there any need to commit your money for a fixed period. Bank and building society deposits can be held within Isas, as can shares, bonds and pooled funds such as unit and investment trusts.
Since Gordon Brown used his first budget to abolish the dividend tax credit, shares and share-based funds held in Isas or pensions can no longer be described as tax-free because tax deducted from corporate earnings at source can no longer be reclaimed. However, both Isas and pensions continue to save individual investors the bother of recording these investments — and any income or gains from them — in their annual tax returns. For those who hate paperwork, that exemption alone may justify using the £7,000 per annum per person Isa allowance.
Many stockbrokers and some fund managers offer self-select Isas, in which you pick the assets to be held, although you cannot simply transfer shares or bonds you already own; for reasons which remain obscure, assets already owned must first be sold and then bought back into the tax shelter.
However, all profits on any assets held in an Isa remain free of capital gains tax. It is worth noting that Isa allowances remain tied to the fiscal year. You cannot subsequently go back and make use of earlier years’ Isa allowances; so it really is a case of ‘use them or lose them’.
Just how valuable these allowances have proved over the years is demonstrated by some calculations the Investment Management Association did for me. I asked them how much an investor could have sheltered from tax in Isas (and their forerunners, personal equity plans or Peps) if all the annual allowances had been taken up since Peps were introduced nearly 20 years ago.
When you consider this period began just a few months before the stock market crash of October 1987 and includes the bursting of the dotcom bubble in April 2000, the answer is quite encouraging. If the full Pep and Isa allowances had been invested in the average UK All Companies unit trust there are some 270 of these to choose from — then total investments of £113,200 would have grown to £273,800 by last month. That’s a return of more than 140 per cent after deduction of initial charges.
While the contents of the Chancellor’s red box for next week’s Budget remain a mystery to me at the time of writing, there are other, more esoteric tax shelters which may be considered. Venture Capital Trusts offer the most generous tax incentives, including 40 per cent initial relief for basicrate taxpayers, but these are due to expire on 5 April. VCT promoters hope the Budget may bring a reprieve and point to their success in stimulating investment in small and start-up companies. But this may be wishful thinking.
As the rules stand, individuals can invest up to £200,000 in VCTs — which would knock £80,000 off their income tax bill and, provided they remain invested for at least five years, any dividends or capital gains generated by VCTs are tax-free. Unsurprisingly, substantial risks accompany such mouth-watering incentives. Small companies are usually less well equipped to survive unexpected setbacks. They are also usually less diversified than large companies and so more exposed to sector-specific risks. Put another way, prospective VCT investors should remember that not every acorn turns into an oak. No such worries apply to Child Trust Funds. This is the newest of tax shelters and one of the most widely misunderstood. Every child born on or after 1 September 2002 should have been sent a CTF voucher for at least £250. But HM Revenue & Customs admitted earlier this month that 820,000 of the 2.3 million vouchers sent out have yet to be invested by parents or guardians on the children’s behalf.
Part of the explanation may be the fact that no cash can be withdrawn from a CTF before the child reaches 18. Some adults may be dithering about whether to choose a deposit-based CTF or a share-based one, though they should be aware that there was a 99 per cent probability of shares beating deposits over any period of 18 consecutive years during the last century.
Part of the explanation may also be that savers are so bamboozled by the Chancellor’s habit of offering money with one hand while taking it away with the other that they simply do not believe CTFs are a no-strings-attached freebie. But they are, and pragmatic savers should set cynicism aside and make the most of the tax shelters available. It’s only prudent, as Gordon might say.