3.2.2 Tax-efficient savings
In the following video, David Harrison of True Potential LLP argues the case for using Individual Savings Accounts (ISAs) to build up a fund for retirement income. David explores why this may be a better route to building up pension savings than using conventional pension schemes. David also highlights the way that successive governments in the UK have changed the tax rules applying to pensions – a comment which is particularly apposite given the significant changes to tax relief on pension contributions and to the taxation of pension benefits that have taken place recently.
Having reviewed the main types of financial investments – and prior to examining conventional pension schemes in the next few sections – we should look at how tax-efficient investments can be used to build up a savings pot to draw on in later life.
Rather than making contributions to occupational or personal pension schemes many people prefer to make their own investments. There is much scope to invest in tax-efficient schemes – particularly now that the annual limit on investing in ISAs has been raised so much in recent years. In 2018/19 the limit for such investments is £20,000 per person. The income and capital gain on these investments are not subject to taxation and this helps the aggregate saved amount build up over the years.
When investing for the long term there is also scope to choose Stocks & Shares ISAs, rather than Cash ISAs, given the likelihood – based on historical evidence – that these will perform better over the longer term.
An attraction of going alone in building up savings for the future is that ISA products can be simpler and easier to understand than pension products.
Those aged under 18 years can start early by investing in Junior ISAs. In 2018/19 the annual allowance is £4,260 per child.
As you saw earlier this week, from 2017/18, lifetime ISAs have been available for those under the age of 40, with an annual investment limit of £4,000, designed to help with property purchase or income in retirement.
Other tax-efficient ways to save for the future include onshore and offshore bonds. These are investments that have the form of insurance policies and attract a favourable tax treatment for the investor.
With onshore bonds the tax planning benefit is that income and capital gains can be rolled into the investment over time and it is only subject to life fund tax (where the funds are taxed as though the investor had paid the basic rate of income tax on the gains made by the fund). Withdrawal of up to 5 per cent of the fund can also be made each year without immediate liability to tax. This annual limit can be carried forward if not used, though the aggregate carried forward cannot exceed 10 per cent. The major benefit arises from cashing in the bond, or accessing funds above the annual tax-deferral allowance of 5 per cent of the investment, when you are no longer a taxpayer or have moved overseas and have become a non-UK resident for tax purposes. So onshore bonds allow the returns on the bonds to be rolled up to a point in time when drawing on the investment can be done with a limited or nil liability to tax.
With offshore bonds, which are held in overseas countries, there is the additional benefit of all the income and capital gains being allowed to roll up on a gross basis with no liability to life fund tax. This allows the funds invested in offshore bonds to roll up more quickly than those in onshore bonds. There may, though, be a liability to a typically small withholding tax levied by the overseas country’s government which cannot be recovered even by non-taxpayers.
The bonds are more complex than ISA products and consequently advice should be sought before investing in them. Investments in certain of these bonds may also present ethical issues for investors. Additionally, offshore bonds are not normally covered by the UK’s consumer protection rules. They can, though, form an effective way to save in a tax-efficient way for the future.