Making the most of tax-efficient schemes

As an adviser, my first port of call with clients is often to ensure they have used their tax-efficient pension and ISA allowances. This is perhaps even more imperative today, when some tax allowances are being frozen and others have been reduced (1).

Pensions and ISAs are familiar to many people. Nonetheless, even apparently knowledgeable individuals can find they have not fully utilised these tax-efficient opportunities.

Moreover, some tax allowances, such as the personal savings allowance and friendly society tax-exempt savings plans, are not that well known. The same potentially goes for premium bonds, which offer a pool of tax-free cash prizes linked to prevailing interest rates. And some people are unaware of the £9,000 annual Junior ISA (JISA) tax-efficient allowance they could use for their children.

Stocks and shares ISAs

There are four types of ISAs: cash ISAs (savings accounts that pay interest free of income tax), lifetime ISAs, innovative finance ISAs, and stocks and shares ISAs. But there are only two types of JISAs: cash JISAs and stocks and shares JISAs. For simplicity’s sake I will focus just on the stocks and shares ISA, which is a wrapper in which savings and investments are free of income tax and capital gains tax.

Anyone aged 18 and above can save up to £20,000 in a tax year in a stocks and shares ISA. The ISA doesn’t expire when the tax year finishes, but remains open for as long as the ISA remains invested. And a new allowance is available each tax year allowing more savings to be added into an ISA wrapper. Some stocks and shares ISAs also allow you to reinvest any withdrawals from the ISA, so long as you do so in the same tax year.

A stocks and shares ISA can include:

• investment funds and unit trusts

• company shares

• government bonds

• corporate bonds.

A key benefit of current tax rules is that a deceased person’s ISAs can be transferred fully to the surviving spouse. Indeed, I know someone who will have more than £1 million in ISAs once his late wife’s ISAs are transferred to him.

Moreover, ISAs can hold AIM share portfolios. AIM is a London stock market for shares in small and medium-sized companies. Once an AIM portfolio is held for two years, it is effectively free of inheritance tax (technically, the portfolio value is subject to inheritance tax, but at a current rate of 0 per cent). This means these portfolios could be passed on to loved ones with no inheritance tax liability.

Pension facts

Turning now to pensions, you could previously contribute tax-efficiently to pensions during your lifetime as long as the value of your pensions did not exceed the lifetime allowance of £1,073,100. But this lifetime limit was removed in the March 2023 budget, so there is currently no limit to how much you can contribute during your lifetime.

Even so, there are limits to how much you can contribute each year. You can normally invest up to £60,000 a year tax-efficiently into a pension (this includes any contributions from your employer). However contribution levels are connected to what you earn, limiting you to 100 percent of your income if you earn less than £60,000. Non-earning individuals can also invest in a pension, but this is limited to an annual maximum of £3,600. Pensions tax rules mean non-earners only need to contribute £2,880 and HMRC will then bring the total contributions to £3,600 by adding £720 of basic rate tax relief.

People who haven’t contributed the maximum amount to their pensions in the preceding three years can use something called ‘carry forward’. This lets you make pension contributions greater than the annual allowance up to the unused relief amount brought forward, yet still enjoy full tax relief. Note that this relief is based on your earnings in the current tax year.

The amount you can pay into a pension tax-efficiently could reduce if you earn more than £200,000 a year. See our article on Tapered pension allowance for high earners for more details.

As well as maximising ISAs and pensions, you could also consider maximising personal allowances, such as personal savings allowances.

Other tax-efficient opportunities

The personal savings allowance lets you earn interest tax-free on your savings, with the annual tax-free limit dependent on your income tax rate, as follows:

Additional rate (45 per cent) taxpayers are not given a personal savings allowance.

You might also look at holding premium bonds. In December 2023, the annual prize rate was 4.65 percent and prizes are tax-free (2). But the odds of winning a premium bond prize are just 24,000 to one (for every £1 bond). So you would need to hold a significant amount of them to have a good chance of reaching the annual prize rate. You can hold up to £50,000 in premium bonds.

In addition, you can pay up to £25 a month, or £270 a year, into a tax-exempt savings plan with a friendly society over a term of 10 to 25 years. A friendly society, like a building society, is a mutual association owned by its members. The savings plan is a kind of fund that invests the pooled money from its members into various assets, which can include shares, bonds, property and cash. But in order to qualify for the tax-free status, the policy must be held for the full term or until the death of the policy holder (3). And early surrender could mean you get back less than you invested and that you could potentially be liable for tax on any investment gains (4).

Once you have made full use of mainstream tax allowances (or even decided not to make full use of them), then you can consider other investments such as offshore and onshore bonds, Enterprise Investment Schemes (EISs), Venture Capital Trusts (VCTs), and investments qualifying for inheritance tax business relief, if suitable. These can be tax-efficient in some circumstances.

Finally, couples can try to maximise their combined allowances by taking advantage of any differences in their individual tax bands when setting up investments. But, as is the case with financial planning in general, this can be complex and you may want to seek the advice of a good financial adviser. At Schroders Personal Wealth one of our key principles is to have regular reviews with an adviser. Financial advisers monitor changes to tax allowances and can help ensure you are making the most of tax opportunities, in line with your specific needs and circumstances.

Sources:

(1) Gov.uk, ‘The Autumn Statement 2022 speech’, 17 November 2022.

(2) www.nsandi.com, ‘Interest Rates’, 12 December 2023.

(3) Gov.uk, ‘IPTM8410 - Friendly society tax exempt policies: premium limits: sole policyholders’ and ‘IPTM8420 - Friendly society tax exempt policies: qualifying policy rules: minimum capital sums payable’, 25 September 2023.

(4) Sheffield Mutual, ‘Tax exempt savings plan with life insurance’, May 2020.