The tax regime, while never going to please everybody all of the time, is a relatively fair system and contains a myriad of options that everyone can potentially use to reduce their tax bill. Here is a quick summary of the available options:
ISAs
ISAs, the acronym stands for Individual Savings Account, were first introduced in 1999 as a tax-sheltered financial product designed to encourage savers. While interest on cash savings or income and profits made on stock market investments are normally taxed as income or capital gains tax, that is not the case when held within an ISA wrapper. Any interest earned on money held in a cash ISA or income and profits from shares or funds held in an investment ISA are untouched by the taxman. There is, however, a limit and the value of cash or investments that can be placed in a tax-sheltered ISA each year is capped at £20,000, which can be split between cash or investments.
There are a number of different ISAs: Cash ISAs can be used to hold cash only. They operate in the same way as a savings account but with the added benefit that interest earned on the balance is tax free. Investment ISAs can be used to hold company shares and funds and many investment ISA products can hold both investment and cash holdings in the same account. Any income from dividends or profits from share and fund trading are tax free. Lifetime ISAs, or LISAs, are another relatively new form of ISA and are available to those between the ages of 18 and 39 only. However, once opened, savers can keep taking advantage of LISA rules up until the age of 50. LISAs are something like a combination between an ISA and a pension and offer a 25% Government top-up on up to £4000 a year. The £4000 does count towards the general £20,000 ISA allowance and is not an addition to it, making this not only great for sheltering returns from tax but also recovering standard rate income tax paid, plus an additional 5%. Junior ISAs allow parents and legal guardians to take advantage of an additional £4128 ISA allowance if they would like/are able to save and invest on behalf of their children.
Private and Workplace Pensions
There are some very attractive tax breaks for anyone contributing towards a private or workplace pension. Essentially, up to a maximum of £40,000 a year, income tax paid on earnings is clawed back on all contributions paid into a pension wrapper. Additionally, as in the case of ISAs, interest payments on cash holdings or returns from investments are also sheltered from tax.
This all makes payments into a pension particularly attractive from a tax efficiency standpoint, with the advantage especially pronounced for those in a higher tax bracket.
Workplace pensions are now obligatory with all employees and employers making minimum contributions through auto-enrolment. The employee contributes 1% over the current tax year, rising to 5% by 2019. Employers’ contributions are currently 1% rising to 3% in 2019. For those happy with their workplace pension provider and choices, it makes sense to contribute more to it than the minimum auto-enrolment requirements. Up to the £40,000 allowance, additional contributions still benefit from the Government tax-back top-up.
Private Pensions of the stakeholder pension variety work in pretty much exactly the same way as a workplace pension. The pension holder will choose from a choice of funds with different return targets and risk categories that their contributions will be invested in. Private stakeholder pensions are a good option for those who are not wholly satisfied with the range of choices on offer from their workplace pension or would like to diversify. There is no reason why someone cannot hold both a workplace pension and a private pension and pay into both.
SIPPs, or Self Invested Pension Plans, are the other main category of private pension. This pension product for more experienced DIY investors takes advantage of all the same tax breaks as other pension products but can hold a wider range of asset classes. SIPPs can be connected to a stockbroking account and can hold individual company shares as well as funds and a list of approved alternative asset classes such as commercial property. The variety of approved asset classes that can be held within a SIPP varies between products and providers.
As well as the employer’s contribution, the government also tops up the employee contribution by an additional 20%, effectively returning standard rate income tax. Most pension products will apply for this top-up on behalf of the holder.
EIS/SEIS Investments
A further investment vehicle that offers attractive tax-offsetting features for high net worth individuals and sophisticated investors is the EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Scheme) schemes. These schemes were initiated to encourage private investment in promising young business ventures, or startups, and are very generous indeed, reflecting the high-risk nature of this type of investment. When investing through EIS, investors can claim income tax relief of 30% on investments in qualified young companies of up to an annual value of £1 million and no minimum level. In the case of SEIS, which companies in their very initial stages qualify for, income tax relief of 50% can be claimed on the investment.
Charitable Contributions
And finally, anyone in the higher or additional income tax rates making altruistic charitable donations to charities or community amateur sports clubs can also offset these against income tax. When the donation is made a Gift Aid form should be filled in. The first and primary advantage to Gift Aid is that the charity itself will receive an additional £0.25 from the Government for every £1 donated. The second advantage is that anyone paying a 40% or 45% income tax rate can also reclaim the difference, as long as donations made do not total more than 4 times the total amount of tax paid that tax year.