Neil MacLeod talks diversification of tax wrappers to maximise tax-free allowances
Financial planning often requires the ability to recommend a suitable "income" strategy for a client. You could be dealing with a business owner, someone in retirement or the trustees of a trust. But no matter why the income is required, tax efficiency is a key factor in determining what investments are recommended.
It's now possible to access the majority of investment funds via most tax wrappers but the tax treatment differs depending on which wrapper you invest in. Creating the right blend of investments for a particular client therefore requires important consideration.
In this article, we consider how to maximise tax-free income using the various allowances and exemptions available.
Unless your client has adjusted net income in excess of £100,000 per annum, the first £12,570 of taxable income will fall within the personal allowance and, as such, will be tax-free. Keeping salary within the personal allowance is not an option for many, so most have to accept that earnings during their working lifetime will be at least partially taxable.
However, many business owners have the potential of setting their own salary, deriving the balance of immediately required income from dividends and taking advantage of employer pension contributions for the balance of available profits. Managing profit extraction can make a considerable difference to the level of tax to be paid both now and in the future.
On retirement, the use of a flexi-access drawdown pension allows pension income to be varied, or turned on and off, as individual need requires. Use of this flexibility of income to, when linked to the use of pension commencement lump sum, offers a very tax-efficient and flexible form of income.
For those who have personal allowance available, an offshore bond may also be appropriate. Offshore bonds grow in a largely tax-free environment, so if you can realise gains without having to pay tax these can be extremely tax efficient.
Starting rate for savings
Those with non-savings (earned) income in excess of £17,570 need not concern themselves with the starting rate of tax. However, if your client does not work, derives income mainly from investments, or can vary income as required, the starting rate can be very useful.
If any taxable savings income falls within the first £5,000 of the basic rate band, your client will not pay any tax on it, as the starting rate for savings income is 0%. With interest rates so low bank accounts, interest-producing OEICs and chargeable gains on insurance bonds fall into this category.
Personal savings allowance (PSA)
The PSA is available for basic and higher rate taxpayers who receive an allowance of £1,000 or £500 respectively. In the same way as the starting rate, savings income within this band is taxed at 0%. In contrast to the starting rate, however, the PSA is potentially available for those with income in excess of £17,570.
However, given the current level of interest rates available from high street bank/building society accounts (approx. 0.1%), you'd need £1,000,000 invested to exceed this allowance (for a basic rate taxpayer), so perhaps alternative investments, such as OEICs (where the fund has more than 60% invested in assets generating interest), are worth considering if this allowance is to be fully utilised. Offshore bond gains within the PSA will also be free from tax.
Like the PSA, the dividend "allowance" is actually a nil rate band in which £2,000 of dividends are taxed at 0%. The £2,000 amount is available to everyone regardless of income level/tax position.
Based on a yield of 3%, an investment of approximately £66,000 in OEICs would be required to generate this amount of dividend. So, assuming that such an investment suits the risk profile, dividend-producing investments can be a useful tool in boosting the level of tax-free income irrespective of current tax position.
Capital gains tax (CGT) annual exempt amount
Everyone receives an annual exempt amount each year for capital gains. For the current tax year this means you can crystallise gains up to £12,300 which are exempt from tax.
Encashing part of an OEIC portfolio is a good way of crystallising capital gains and the capital released with the gain would also boost "income".
If you can make use of all the allowances mentioned above a tax free "income" of £32,870 can be achieved in just one tax year. However, you can't use all these allowances with a single type of investment. Neither the dividend allowance or CGT exemption will be used by investing in a bond. And an OEIC portfolio is unlikely to be sufficiently invested in interest generating funds to fully use the savings allowances.
Diversifying a client's portfolio between asset classes has long been standard practice because not holding all your eggs in one basket can help generate better returns. The same should also be said about diversification of tax wrappers.
Neil MacLeod is technical manager at Pru