Tax efficiency is a key consideration when investing because it can make such an enormous difference to your wealth and quality of life. However, the type of investment and tax-efficiency you should be looking for depends firstly on whether your priority is to save a lump sum for the future, or to draw an income today.
When it comes to accumulating wealth through saving, the two most obvious tax-efficient vehicles are ISAs and pensions. ISAs allow you to invest up to £20,000 each year, with all growth and income free from tax. Withdrawals are also tax free, because the money paid in was from after-tax income.
Pensions are difficult to beat from a tax-efficiency standpoint. All contributions are topped up by the government with tax relief payable at your highest rate of tax. For example, it would only cost a basic-rate taxpayer £80 to contribute £100 into their pension because they would receive tax relief at 20%. This is added to the £80, representing the 20% tax they would have paid if they had earned that £100.
For higher earners it is even better, with higher-rate taxpayers only needing to contribute £60 in order to boost their pension fund by £100, and additional-rate taxpayers only needing to pay £55.
It is sound advice to take advantage of these generous tax breaks while you can because there is constant talk of the government potentially cutting tax relief on pensions.
But there is more to tax efficient investing than these two schemes.
For example, there are Enterprise Investment Schemes (EISs), and Seed Enterprise Investment Schemes (SEISs), which offer very generous tax breaks in return for investing in high risk, early-stage companies.
Venture Capital Trusts also offer incentives to investors but once again, only those who can afford to take the risk should consider them.
When it comes to investing for income, it is possible to substantially increase the amount of money you can draw by not only investing in the right products, but withdrawing your income from the correct schemes in a certain order. Our research show that more than half of people do not know what they are going to do with their pension pot on retirement, even though it is one of the most crucial financial decisions we will ever make. In addition, it can require a finely-calibrated strategy if retirees want to maximise their retirement income.
Creating a generous income in retirement involves carefully-calculated withdrawals from the right products at the right time. It can involve making use of the tax-free annual personal allowance, the 25% tax-free element of the pension, the personal savings allowance and the annual £2,000 dividend allowance. In other words, there is so much to juggle and so many moving parts.
Tax-efficient investing is about so much more than ISAs and pensions. It is about choosing the right investments now and ensuring that they dovetail together so that their features complement each other when you need to draw on the funds. It is a skill that you only appreciate when you have seen the benefits yourself because it is such a complex area to explain.