According to Benjamin Franklin, ‘In this world, nothing is certain except death and taxes’. Three centuries later, this statement is still true, and while tax implications should not be the only thing to consider when choosing your investment, there is no harm in considering savings vehicles that reduce your tax bill.

What makes long-term planning difficult is that the rules surrounding tax are routinely tampered with by the government. One of the key announcements in Alistair Darling’s Pre-Budget Report was that the rules on capital gains tax (CGT) will change as of 6 April this year.

Anticipated changes
Darling announced a new 18 per cent flat rate to replace the current system of taper relief that allows investors to pay as little as ten per cent CGT on profits from the sale of assets in any unlisted company or publicly listed firm they work for, as long as they have held them for two years.

The proposed new CGT flat rate would also apply to capital gains that are not eligible for taper relief, such as the profit made from buying and selling shares in a quoted company. Currently, the tax on these profits is either ten, 20 or 40 per cent, depending on what rate of taxpayer you are.

Mike Warburton, senior tax partner at Grant Thornton, explains, ‘In general, the introduction of an 18 per cent capital gains tax flat rate is good news for many investors with larger portfolios. However, some people are not higher-rate taxpayers, and if you have held an investment for ten years you may only be paying 12 per cent, in which case the proposed CGT flat rate of 18 per cent will not be very beneficial.’

Safe savings
What is clear is that investors want to make the most of the tax breaks available to them. ‘We are seeing big changes in the types of accounts favoured by investors. Five years from now, a third of their cash savings will be in tax-efficient accounts such as individual savings accounts (ISAs) – a massive increase from five years ago, when only 14 per cent were sheltered in this way,’ says Ewan Edwards, head of savings at Alliance & Leicester.

ISAs are a popular tax-efficient savings vehicle, with more than 17 million people in Britain now keeping their money in one. Introduced by the Labour government in 1999, ISAs were designed to replace PEPs and TESSAs, and comprise two main elements: cash and ‘stocks and shares’.

The cash element is usually linked to some form of deposit account, while the stocks and shares element actually covers a wide range of investments, including investment funds and fixed-interest securities, such as UK government gilts and corporate bonds.
The attraction of taking out an ISA is that the proceeds are tax-free in the hands of the investor. Investments held within an ISA are not liable for CGT, nor do any dividends you receive from them have to appear on your income tax form. There are, however, limits to how much money you can put in. Until 5 April, you can invest up to £7,000 tax free and choose between a maxi or mini ISA. But after 6 April, the rules surrounding
ISAs will change slightly.

There will no longer be a distinction between maxi and mini ISAs, and investors will be able to invest up to £7,200 in an ISA each financial year. Up to £3,600 of this can be held in cash, or the whole amount can be invested in stocks and shares.

Venturing out
Venture capital trusts (VCTs) were introduced in April 1995, designed to encourage indirect investment in a range of small, higher-risk trading companies who are looking for further investment to develop their business.

Annabel Brodie-Smith, communications director at the Association of Investment Companies, explains, ‘VCTs allow you to gain exposure at a relatively low cost to a professionally managed portfolio of privately owned companies and AIM- and PLUS-traded shares. They also make an important contribution to the economy by investing in smaller, potentially high-growth businesses that promote innovation, industrial change and modernisation of working practices.’

Traditionally, VCT’s have offered one of the most attractive tax breaks. However, in his previous role as Chancellor of the Exchequer, Gordon Brown imposed extra restrictions in his 2006 Budget (see box summarising these), although VCTs remain a potential source of significant tax-free returns.

Investors in VCTs are entitled to 30 per cent tax relief, which means that every £10,000 you invest will only cost you £7,000, although this relief only applies when you invest in new issues of shares in a VCT or top-ups, not second-hand VCTs. There are also the added benefits of there being no income tax to pay on any dividends and no tax on any capital gains made on the investment.

While this may sound like the perfect tax-efficient investment product, opting for a VCT does have a downside. This comes in the form of risk. Because you are investing in smaller companies, you must be prepared to take a long-term view – usually between five and ten years – and any income derived from it is certainly not guaranteed.

Brodie-Smith points out, ‘As VCTs invest in small, often privately owned, companies, investors need to bear in mind that they are higher risk than investment companies investing in larger, more established companies. VCTs do have significant tax benefits for investors – income tax relief on the initial investment when buying new VCT issues, providing you hold these shares for at least five years, plus tax-free dividends and tax-free capital gains. However, you should not invest in a VCT solely for the tax benefits. It is important to look at the investment case too, as with any other investment.’

Breathing a sigh of relief
With the state pension currently providing a single person with just £87.30 per week, it is important that we start saving for retirement as early as possible. There are many ways to put money aside for the later years, but one of the most popular is a self-invested personal pension (SIPP). A SIPP is a do-it-yourself pension with the added advantage of being very flexible.

With a SIPP, an investment can be chosen from a wide range, including individual shares, investment funds, futures and options, REITs, unquoted shares, gilts (government bonds) and corporate bonds, cash and commercial property.
Angus Rigby, CEO of TD Waterhouse UK, explains, ‘SIPPs provide all the tax advantages of a traditional pension scheme and put the investor in control of where, how and when their savings for retirement are invested.’

When you reach the minimum age of retirement (currently 50 but due to be raised to 55 after 2010), you are able to take out 25 per cent of the fund as a tax-free lump sum and use the remainder to provide a retirement income, either through an annuity or through an income drawdown directly from the fund, which will be subject to tax.

Tom McPhail, head of pensions research at Hargreaves Lansdown, explains, ‘The key determinant with SIPPs is to work out what kind of investor you are. They work best for people who want to take an interest in their retirement planning. It is not about how much money you have because there are now several products that have no fixed
costs, so they are just as efficient for a £1,000 investment as they are for £100,000.

These low-cost SIPPs include Hargreaves Lansdown, Alliance Trust, James Hay and Sippdeal.’But he adds, ‘If you aren’t interested in your pension, then just stick your money in a managed fund stakeholder, come back in 30 years and, if you are lucky, you will have done OK.’

How SIPPs work
When it comes to tax relief, there are limits on how much you can invest. If you are a taxpayer, you can contribute 100 per cent of your earnings before tax, up to a limit of £225,000 for the 2007/08 tax year (this limit will increase by £10,000 every year until 2010/11). If you are not a taxpayer, you can contribute up to £3,600 per year into a SIPP and still get basic tax relief. Basically, this means that you pay £2,808 and the taxman will add £792.

Your pension fund is also able to grow free of tax, so any rise in the value of the scheme’s assets between what you put in and what they are worth at the end is your capital gain and is tax free.

You can also contribute towards someone else’s personal pension, such as your spouse, partner, child or grandchild. They will benefit from tax relief at the basic rate and your tax bill will not be affected.

According to McPhail, where you invest is very important as some SIPPs give better deals on mutual funds, others on cash rates or on share trading, so investors should think in advance where the money will be placed.

He explains, ‘The investment mix of our SIPP, across its 30,000 investors, is typically around 50 per cent in mutual funds,
25 per cent in cash and 25 per cent in direct equities. Beware of the old-style high-charge SIPPs with fixed costs. These are good value if you want a ‘hands on’ bespoke advisory service, but not otherwise. Also look at how good the online services are. A key aspect of SIPPs is effective investor engagement, and the ability to manage your pension yourself. To this end, you need
to be able to access online switching and fund research.’

Avoiding inheritance tax
Death and taxes may be the only two certainties in life but 61 per cent of people in the UK are still failing to take advice about how best to minimise their inheritance tax (IHT) liabilities.

Andrew Stead, head of wealth at Bradford & Bingley, points out that ‘Despite the avalanche of column inches in recent years on the importance of planning for IHT, too many people are burying their heads in the sand and failing to take advice about how best to plan their estate. This could mean 40 per cent of everything owned over and above £300,000 (rising to £312,000 in 2008/09) bypassing loved ones on their death and instead going straight to HM Revenue & Customs.’

He adds, ‘While it is no surprise that planning for death is not at the top of most to-do lists, by seeking advice about how to mitigate against IHT and planning their finances in a tax-efficient way, people can protect their hard-earned assets and protect their families from the burden of financial uncertainty
in the future.’

There is, however, a lot you can do yourself to knock essential pounds off your tax bill, such as making gifts to friends and family, leaving money to a charity and drawing up a will to specify how you would like your estate to be distributed. With the help of an expert, you could make substantial savings, as they can look at your financial situation as a whole and put together a plan for how you can really mitigate tax.

If you need to make a larger gift out of your estate, there is also the option of taking advantage of the potentially exempt transfer (PET) rules. What is meant by ‘potentially exempt’ is simply that the donor has to survive for seven years from the date the gift is made for it to qualify as fully exempt from IHT.

Using the rules
Despite changing rules regarding IHT, it is still possible to use investment vehicles for effective IHT planning, particularly
when they are used alongside assurance-based products. These work on the principle of writing a life insurance policy ‘in trust’ that will pay out a lump sum when you die to cover the IHT liability, leaving your beneficiaries to enjoy the full estate.

Stead concludes, ‘It is disheartening to think that for nearly half of the year we are working simply to pay our tax bill, which is why it is so important that UK taxpayers make their hard-earned cash work for them.

‘If consumers are willing to spend a few spare hours getting their finances in order, rather than spending unnecessary money on taxes, then they could reap substantial rewards in the long term, with a potentially smaller tax bill and greater financial peace of mind.’