How Do High Earners And The Wealthy Invest For Tax Efficiency?
Tax avoidance by the wealthy is something very few are ready to tolerate. After all, the best of members of society can best afford their tax bill. It makes less difference to the standard of living they can afford, after taxes.
But at the same time, HM Revenue & Customs has made over 100 tax breaks available to the wealthy. Many of those are connected to them using their wealth to stimulate the country’s economic development, creating jobs and raising incomes. Or reducing reliance on expensive state-funded services such as care in old age. These tax breaks for higher earners or those lucky enough to have inherited wealth, have been devised by successive governments as win-win.
Tax consultancy Blick Rothenburg says there are 80 efficiencies that can reduce income tax and 35 for inheritance tax. For the wealthy and high earners, not leveraging these legal, win-win tax efficiencies would be tantamount to financial mismanagement.
So what are some of the most popular ways the wealthy legally reduce their tax bills? Let’s take a look and see what the experts have to say about their pros and cons.
Make The Most Of Pre-Tax Allowances
Any couple can save up to £55,000 between them simply by taking full advantage of all the personal allowances before tax available to everyone. A couple’s combined personal income allowance (£12,500 x 2) adds up to £25,000. Combined capital gains tax exemptions combine for another £24,000. Add to that the £4000 dividend allowance and £2000 savings allowance (though that fall to £500 for higher-rate tax payers and zero for additional rate tax payers.
When all of those allowances are combined, the tax saving every year can reach £55,000. A couple can have a combined income of up to £130,000 before qualifying for the higher-rate income tax band.
Invest In One Or A Portfolio of Promising Start-Ups
The government introduced tax incentives for high net worth and high earning individuals to invest in start-ups and growth companies as early as the 1990s – long before the ‘start-up’ and entrepreneurship became as fashionable as it is now. These rules have proven popular but have been tightened up in recent years after being exploited. You’ve probably heard of the television and sports personalities caught up in film investment schemes.
But they still exist and changes to the rules only really affected those who were abusing them, rather than making use of them in the spirit they were intended.
The two main options for investors are the Enterprise Investment Scheme (EIS) and venture capital trusts (VCTs).
EIS, first introduced in 1994, is used for an investment in a single qualifying company. If a company is registered for EIS investment, and doing so means meeting criteria such as maximum turnover, number of employees, years since incorporation and sphere of activity, investors can claim back 30% of their initial investment, up to £1 million per annum (or £2 million if at least £1 million is invested in a company that qualifies as ‘knowledge intensive’) as an income tax credit.
That means for every £1000 invested, at least £300 is claimed back immediately as income tax relief. Dividends realised, though those are rare for growth companies that qualify for EIS, are taxable but capital gains are tax free as long as shares are held for at least 3 years. If the investment sustains a loss, this can also be claimed as tax relief up to the highest rate of income tax you pay. Inheritance tax is also not applicable to EIS investments after shares have been held for at least 2 years.
This significantly reduces the risk involved in a start-up investment, up to 75% of the total investment would be reclaimed in tax credits if unsuccessful, while improving the upside.
Venture capital trust (VCT) investments come with similar tax efficiency incentives. A VCT is basically an EIS fund. The trust’s management invests across a range of EIS-qualifying start-ups, which spreads the risk for investors.
Investments in a VCT, as long as the shares are newly issued, also come with a 30% income tax credit up to £200,000 per annum. Shares in a VCT must, however, be held for at least 5 years before being sold or the tax credit applied will have to be repaid. Capital gains tax and tax on dividends are tax free on VCT investments.
VCT investments have, on average, done well for investors over the last decade, delivering total returns of 140%, based on stats provided by the Association of Investment Companies. One notable VCT success story was property portal Zoopla, which was funded by VCT capital as a start-up and went on to list on the London Stock Exchange.
Investors considering EIS or VCT investments should, however, be aware that investing in start-ups is inherently risky. Which is why the government has offered these tax breaks to balance that risk out to an extent. But such investments should still be considered as ‘high risk/high return’, and shouldn’t form the basis of an investment portfolio relied on to provide an income in later life.
VCT’s are less risky, though still risky compared to standard funds and investment trusts investing in public companies, because they spread investment between a number of start-ups. EIS investments are best considered ‘moonshots’. It they come off, the investor could stand to make very good returns indeed. But there is also a high chance money could be lost.
Investment bonds are a form of life insurance that involves investing a lump sum across a range of funds. Some investment bonds are for a fixed period, while other are rolling. When an investment bond is cashed in, its value depends on how well, or poorly, the funds it is invested in have done.
Income and gains generated from investment bonds are taxed at 20% but you can withdraw up to 5% of the value of your bond annually, for up to 20 years, without any additional tax being applied.
There are, however, some ways to make putting money into an investment bond more tax efficient. One way is to gift the bond to another tax payer, for example a child or grandchild, before it is cashed in. This will see the original bond holder avoid income tax that would have been due. It also reduces inheritance tax, as the bond will no longer represent part of your estate. So a gifted investment bond can represent tax efficient, forward-paid inheritance.
Another option might be to, if possible, reduce income from other sources during the year a bond is cashed in, reducing taxable income. For example, not taking a company bonus in cash but deferrable share option, or halting pension income for a year.
If you do opt for an investment bond, do your research with a particular focus on charges. Some of these products can have expensive charges for withdrawals.
Putting money into a trust can also be a good way to reduce inheritance tax. A trust is a legal structure that holds assets from cash to investments, property or even valuable collectables. The assets held within a trust are looked after by a trustee for the benefit of a third person in whose name you have created the trust.
A trust allows you to take the assets held it holds off the table for inheritance tax that will one day be due on your estate. Until the point the beneficiary takes control of the trust, it also protects its assets from being claimed in the case of their bankruptcy or if they go through a divorce.
Tilney wealth manager Ian Dyall explains:
“This can protect assets from divorce or the bankruptcy of a beneficiary, and the trustees can control who benefits, what they benefit from, when they benefit and how the money is invested.”
The downside to sheltering assets in a trust is that the trust will be taxed 20% when formed if it exceeds £325,000. That’s the inheritance tax ‘nil rate band’. Another 6% tax can also be applied every ten years after the trust is formed. However, this is still generally a more inheritance tax-efficient option than the tax being calculated against assets at death.
Electric Cars Are Tax Friendly
When the time comes for a new car, an electric vehicle represents a tax-efficient option. With the added bonus of reducing your personal emission levels. However, you do need to own a company to take advantage.
If a small business buys an electric car that produces less CO2 than 50g of emissions per kilometre, a capital allowance of 100% can be claimed against the purchase. That means the whole cost of the car can be deducted against taxable company profits. And the car can be used for personal journeys.
Collectables might be rather unpredictable investments but some of them do certainly come with tax advantages. For example, vintage wine and classic cars are classified as ‘wasting assets’, which means their predictable life span of use is less than 50 years, exempting any gains made on their sale from capital gains tax.
When it comes to vintage wines that are made to remain drinkable for potentially a lot longer than 50 years, HMRC is tightening up the rules. The latest manual states:
“[The exemption] would not apply to port and other fortified wines . . . generally recognised to have a very long storage life.”
Classic cars must also be used as private vehicles, as their value will depreciate as mileage increases. The HMRC definition of a classic car is any vehicle older than 15 years with a market value of at least £15,000.
Both categories of collectables have seen average values rise in recent years. Over the last decade, fine wine selling prices have risen by 142% - far superior to the 36.2% return putting money into the FTSE 100 would have resulted in. Classic car selling prices grew by 334% over the last 10 years.
Items defined as ‘chattels’, such as antiques, furniture and paintings are subject to capital gains tax but come with an extra exemption of £6000 in addition to the standard £12,000.
This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.