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Valuing Your Future
Ian McKeever & Co Consulting Actuaries
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Issued by Ian McKeever & Co. Authorised and regulated by the Financial Services Authority in the conduct of investment business
What Government Borrowing means for you
What it means
What it means
High Rate Taxpayers 1
As an investor boring is always good. Exciting is only good, if you like that sort of thing, and you have done the boring stuff first.
The object of any investment strategy is to maximise the amount of money you have at the end of the day after all the tax has been paid. Minimising your tax liability may help achieve that end but it should not be an end in itself.
If saving tax is your first priority a guaranteed way of achieving this is not to make any money in the first place. However this is clearly not a sensible investment strategy. Tax driven investment can easily lead to poor investment decisions. Sometimes making the profit and paying the tax may be the best strategy. The following looks at tax efficient investments grouped by the level of risk.
Boring/Relatively Safe Investments
Index Linked Savings Certificates
These do not provide the very best investment return but they provide absolute protection from inflation, the returns are tax-free and there is government guarantee. If a higher rate taxpayer can get 6% on a deposit, he or she will end up with net interest of 3.6%. As at the time of writing (July 08) Index linked Savings certificates give 1% over inflation that means that if inflation exceeds 2.6% it beats the deposit account.
Investments are limited to £15,000 per issue but you can reinvest the proceeds from previous issues as well as the proceeds from fixed interest certificates. There are generally two issues available at any one time with different terms. Interest rates do change and therefore new issues tend to be fairly frequent which means that you can invest another £15,000 or even £30,000 in the two new issues. Because old certificates can be reinvested in new ones substantial holdings can be built up.
Cash ISAs
You want to have some cash investments and interest on Cash ISAs is tax-free. Rates are competitive generally. It is probably worth consolidating your investment into a small number of accounts. Many accounts offer stellar interest rates in the first year and poor interest rates afterwards so look out for accounts that take transfers from previous years. See equity ISA to see why a cash ISA are better.
Pensions Policies
This is a wrapper rather than an investment. Premiums are tax deductible, a quarter of the benefit is tax-free but eventually the rest must be taken as pension. The earlier you invest the better and the greater are the tax benefits. You cannot get at the money at all until you are 55 (50 before 2010). Pension arrangements can be as boring or exciting as you make them. See section on retirement). However they are here because if you are under 50 the amount you can get out next year is guaranteed. It is guaranteed to be nothing unless you die.
Once a substantial fund has been built up you may wish to move to a stockbroker managed SIPP in order to have more control and better manage your overall portfolio.
Fixed Interest Savings Certificates.
Interest rates are fair and tax-free but also offer rollover into Index Linked later.
Equity ISAs
These are worth having because at least notionally they are tax-free. However the government has changed the taxation of dividends and so dividends now effectively come with a non-recoverable basic rate tax credit rather than being tax free. Capital gains are however tax-free within an ISA. They are possibly a better vehicle for investing in bonds rather than equities because coupon is tax free. Many fund managers offer equity ISAs on competitive terms but once you have built up a portfolio over a number of years you should consider transferring to a stockbroker managed ISA. That way you have greater freedom of investment and you can manage your ISA portfolio along with your other holdings. An Equity ISA is a wrapper. The investments inside it can be as risky as you like but even with bonds there is some risk.
Friendly Society policies
Limited to £25 a month and they must be for a term of at least 10 years but the underlying fund and the benefits are tax-free. Because of the small premium size expenses tend to be fairly high. This is one of those “might as well have” investment.
Premium Bonds
The underlying yield is 3.4% with 94% of that going in prizes of less than £5,000. You can therefore, as at August 2008, expect to get a return of 3.1% to 3.2% free of tax. This is equivalent to a gross yield of 5¼%. Various small cheques coming through the post may be a mixed blessing. You may win a million pounds but you probably won't. Not bad as an investment but not wonderful either. Better returns are available elsewhere. In any event check on current rates with NSI.
Qualifying Endowment policies.
Policies must for at least ten years with a regular premium. Ideal for someone who spends money as quickly as they can make it, but feels that they should save. Loads of penalties on early surrender at which time there may be exposure to stockmarket movements. The proceeds are tax-free but the insurer pays tax effectively at the basic rate. An ideal vehicle for investing regular level amounts into the stockmarket when the outlook is volatile as that volatility will reduce the average cost of units.
Second-hand Endowments
Generally subject to capital gains tax which is now at 18%. Some risk if terminal bonuses fall but relatively safe and fair to good returns should be expected. However, there are risks see more detailed discussion Second-hand Endowments and Reversions
Zero Coupon Preference Shares
These are low risk, at least in principle. They are shares in split capital investment trusts. An investment trust is a quoted company that invests in other companies. They are like unit trusts except that they are closed end, in that once the money is raised no more is taken in and investors have to buy and sell on the stockmarket at the prevailing price of the shares. That price will be related to the value of the underlying assets but not determined by it. Share prices are frequently less than the value of the underlying portfolio although they may be higher. Unlike unit trusts, investment trusts can also borrow money, which enhances returns in good times and magnifies losses in bad times.
Split capital investment trusts have a fixed windup date, at which point the assets of the trust will be distributed to the holders of the various classes of share. The holders of the zero coupon preference shares receive a fixed sum when the trust is wound up, assuming that the value of the trust assets is sufficient to provide it. The other classes of share get the dividends and any money left over, after the holders of the zero coupon preference shares are paid their entitlement.
If the investment trust has no borrowing and has assets sufficient to pay the zeros off two times over, the stock market has to fall by about 50% before the zeros start getting less than they are entitled to. However most of these trusts do have borrowings, stockmarkets can halve in value and in particular trusts may hold portfolios likely to show high volatility.
Zeros are not risk free investments and different trust shares have different risk profiles and so expert advice is needed when investing in them. However, with expert advice a portfolio of zeros can be constructed to provide a reasonably stream of capital gains in future tax years. Gains of up to £9,600 in the current tax year (year 2008-2009) are tax-free. Additional gains are taxed at 18%. Zeros are not so boring as the other investments listed above and there is risk and advice is needed.
The object of any investment strategy is to maximise the amount of money you have at the end of the day after all the tax has been paid. Minimising your tax liability may help achieve that end but it should not be an end in itself.
If saving tax is your first priority a guaranteed way of achieving this is not to make any money in the first place. However this is clearly not a sensible investment strategy. Tax driven investment can easily lead to poor investment decisions. Sometimes making the profit and paying the tax may be the best strategy. The following looks at tax efficient investments grouped by the level of risk.
Boring/Relatively Safe Investments
Index Linked Savings Certificates
These do not provide the very best investment return but they provide absolute protection from inflation, the returns are tax-free and there is government guarantee. If a higher rate taxpayer can get 6% on a deposit, he or she will end up with net interest of 3.6%. As at the time of writing (July 08) Index linked Savings certificates give 1% over inflation that means that if inflation exceeds 2.6% it beats the deposit account.
Investments are limited to £15,000 per issue but you can reinvest the proceeds from previous issues as well as the proceeds from fixed interest certificates. There are generally two issues available at any one time with different terms. Interest rates do change and therefore new issues tend to be fairly frequent which means that you can invest another £15,000 or even £30,000 in the two new issues. Because old certificates can be reinvested in new ones substantial holdings can be built up.
Cash ISAs
You want to have some cash investments and interest on Cash ISAs is tax-free. Rates are competitive generally. It is probably worth consolidating your investment into a small number of accounts. Many accounts offer stellar interest rates in the first year and poor interest rates afterwards so look out for accounts that take transfers from previous years. See equity ISA to see why a cash ISA are better.
Pensions Policies
This is a wrapper rather than an investment. Premiums are tax deductible, a quarter of the benefit is tax-free but eventually the rest must be taken as pension. The earlier you invest the better and the greater are the tax benefits. You cannot get at the money at all until you are 55 (50 before 2010). Pension arrangements can be as boring or exciting as you make them. See section on retirement). However they are here because if you are under 50 the amount you can get out next year is guaranteed. It is guaranteed to be nothing unless you die.
Once a substantial fund has been built up you may wish to move to a stockbroker managed SIPP in order to have more control and better manage your overall portfolio.
Fixed Interest Savings Certificates.
Interest rates are fair and tax-free but also offer rollover into Index Linked later.
Equity ISAs
These are worth having because at least notionally they are tax-free. However the government has changed the taxation of dividends and so dividends now effectively come with a non-recoverable basic rate tax credit rather than being tax free. Capital gains are however tax-free within an ISA. They are possibly a better vehicle for investing in bonds rather than equities because coupon is tax free. Many fund managers offer equity ISAs on competitive terms but once you have built up a portfolio over a number of years you should consider transferring to a stockbroker managed ISA. That way you have greater freedom of investment and you can manage your ISA portfolio along with your other holdings. An Equity ISA is a wrapper. The investments inside it can be as risky as you like but even with bonds there is some risk.
Friendly Society policies
Limited to £25 a month and they must be for a term of at least 10 years but the underlying fund and the benefits are tax-free. Because of the small premium size expenses tend to be fairly high. This is one of those “might as well have” investment.
Premium Bonds
The underlying yield is 3.4% with 94% of that going in prizes of less than £5,000. You can therefore, as at August 2008, expect to get a return of 3.1% to 3.2% free of tax. This is equivalent to a gross yield of 5¼%. Various small cheques coming through the post may be a mixed blessing. You may win a million pounds but you probably won't. Not bad as an investment but not wonderful either. Better returns are available elsewhere. In any event check on current rates with NSI.
Qualifying Endowment policies.
Policies must for at least ten years with a regular premium. Ideal for someone who spends money as quickly as they can make it, but feels that they should save. Loads of penalties on early surrender at which time there may be exposure to stockmarket movements. The proceeds are tax-free but the insurer pays tax effectively at the basic rate. An ideal vehicle for investing regular level amounts into the stockmarket when the outlook is volatile as that volatility will reduce the average cost of units.
Second-hand Endowments
Generally subject to capital gains tax which is now at 18%. Some risk if terminal bonuses fall but relatively safe and fair to good returns should be expected. However, there are risks see more detailed discussion Second-hand Endowments and Reversions
Zero Coupon Preference Shares
These are low risk, at least in principle. They are shares in split capital investment trusts. An investment trust is a quoted company that invests in other companies. They are like unit trusts except that they are closed end, in that once the money is raised no more is taken in and investors have to buy and sell on the stockmarket at the prevailing price of the shares. That price will be related to the value of the underlying assets but not determined by it. Share prices are frequently less than the value of the underlying portfolio although they may be higher. Unlike unit trusts, investment trusts can also borrow money, which enhances returns in good times and magnifies losses in bad times.
Split capital investment trusts have a fixed windup date, at which point the assets of the trust will be distributed to the holders of the various classes of share. The holders of the zero coupon preference shares receive a fixed sum when the trust is wound up, assuming that the value of the trust assets is sufficient to provide it. The other classes of share get the dividends and any money left over, after the holders of the zero coupon preference shares are paid their entitlement.
If the investment trust has no borrowing and has assets sufficient to pay the zeros off two times over, the stock market has to fall by about 50% before the zeros start getting less than they are entitled to. However most of these trusts do have borrowings, stockmarkets can halve in value and in particular trusts may hold portfolios likely to show high volatility.
Zeros are not risk free investments and different trust shares have different risk profiles and so expert advice is needed when investing in them. However, with expert advice a portfolio of zeros can be constructed to provide a reasonably stream of capital gains in future tax years. Gains of up to £9,600 in the current tax year (year 2008-2009) are tax-free. Additional gains are taxed at 18%. Zeros are not so boring as the other investments listed above and there is risk and advice is needed.
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