'In my last article - Understanding your Investment Choices I ended with a quote from Benjamin Graham: “Successful Investing is about managing risk, not avoiding it.” I concluded that for the everyday saver owning a combination of the main asset classes - Cash, Fixed Interest Investments, Property and Shares was often the most effective way to invest. Savers should remember that the theory of diversification can be applied to their existing savings and investments – by considering the products they own. Alongside tax efficiency this is a powerful combination.'
Tax efficient investment products
There are three common tax-efficient investment products - ISAs, Pensions and Investment Bonds. All too often I hear people say, “My ISA hasn’t done very well,” or “Pensions aren’t very good, are they?” to which I reply, “The ISA and the pension are not usually the problem, it is the underlying investment that is normally the issue.” I prefer to call these products ‘tax wrappers’ as they simply wrap around investments. What is key is selecting the most suitable investments and the most appropriate wrapper for your personal circumstances. The key wrappers include:
ISAs have tax advantages. You do not pay tax on the interest earned on cash or fixed interest investments, or on rental income from property and dividends on shares. There is no tax to pay on capital gains either, so for most taxpayers it makes sense to hold cash and investments within an ISA wrapper up to their annual contribution limit. Help to Buy ISAs and Lifetime ISAs also have additional tax advantages.
Investment bonds are common and offered by the larger insurance companies. There are two types of funds; With Profits or Unit-Linked and both have the same tax rules. Onshore bond Income and growth is taxed within the bond by the insurer, which allows the holder to draw out up to 5% of the amount invested without any immediate tax liability. Offshore bonds are available which defer tax on income and growth.
Many people own investment bonds because they appear simple and they treat the 5% withdrawals as income, but in many instances the growth of the investment is being reduced by the ongoing “tax-drag” within the bond.
Controversial and often tinkered with by the government, but still a highly tax efficient way to save for retirement. Many different schemes exist from simple workplace pensions to Self-Invested Personal Pensions (SIPPS). The most appropriate scheme will depend on your personal circumstances. This includes your earnings, age to retirement and income plans at retirement. Pensions benefit from the same tax treatment as ISAs, but with the additional benefit of tax-relief on contributions. The disadvantage is that you cannot access them until age 55 and may pay tax at that point on capital and/or income (although the ways you can access pensions is far more flexible now than ever before).
You could theoretically own exactly the same underlying investments (hopefully properly diversified) within an ISA, a Pension or an Insurance Bond. However, the return you receive would be different.
A simplistic example is detailed below assuming a basic rate taxpayer, a £40000 investment and a 5% return:
ISA valued at £40000 x 5% =£2000 return
Investment Bond valued at £40000 x 5%=£2000 return less corporation tax @ 19%=£1620 return
Pension valued at £40000 x 5%=£2000 return. Basic rate tax relief into the pension reduces the cost for the individual to £33334, so the return is £8666. (Please note - there are additional rules around maximum contributions into pensions and taxes when drawing the benefits).
Howard Goodship, chartered financial planner and member of the Ringwood financial planning team continued:
'The right choice of wrapper will depend on your personal circumstances and I recommend seeking professional advice. Making the right choices now will results in you earning, and keeping, more of your returns and will help make your financial goals more achievable. If you are new to investing please review our guide – A beginner’s guide to investing. In the next article, I will review investments costs and the value of advice.'
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. The contents of this article are for information purposes only and do not constitute individual advice.
For more information read: Howard Goodship, independent financial adviser Ringwood, Hampshire opens Lonsdale Services office in Ringwood; Lonsdale Services win best pension advice firm in 2018 RPA awards.