Pinpointing some pension savings needn't be taxing

Published on Saturday 28 March 2009 17:08

TO GET the most out of any investment, it is important to be tax efficient. Pension contributions obtain income tax relief up to the greater of 100% of earnings or £3,600 (without reference to earnings), with an overall contribution allowance of £235,000 for the current tax year. A self-invested personal pension (SIPP) gives the optimum flexibility, giving income tax relief on the amount invested and tax-efficient growth.

Basic rate income tax relief is granted at outset, meaning a net investment of 8,000 becomes a gross amount of 10,000, an effective increase on the investment of 25%. Higher-rate taxpayers can claim higher-rate tax relief through their self-assessment tax return, reducing the net cost of the investment to 6,000. The total tax relief of 4,000 represents an effective enhancement to the net investment of 66.67%.

It should be noted that only 25% of the value of a portfolio can be taken as a tax-free lump sum, with the rest being used to provide retirement income, and the capital may be locked up for longer than one might wish.

Investors should also consider using their ISA allowance, which allows investment of up to 7,200. This has similar tax treatment on the investment growth as a pension fund, but with the flexibility of being able to access the capital and income at any time, tax-free. An ISA is not an investment itself, but a tax- efficient vehicle in which to hold investments.

For the rest of the portfolio, a collective investment is seen as an ideal way to obtain a diversified portfolio managed by professionals. Income derived from it is usually subject to income tax, with gains on the portfolio subject to capital gains tax. However, good use of the annual capital gains tax allowance (9,600 in the current tax year) will help mitigate liability to this tax. This form of investment also allows capital losses, which can be offset against other gains and may be appropriate in the current financial climate.

Another option is a Capital Investment Bond (CIB), issued by life assurance companies. The underlying fund is subject to tax on its income and capital gains, and investors receive the benefit of a basic-rate tax credit. Tax treatment of CIBs may make them unattractive to those who do not pay tax.

A CIB can be useful to those seeking a regular income, as a tax-deferred withdrawal of up to 5% per annum of the initial investment can be paid without immediate liability. If nothing is withdrawn in year one, 10% can be withdrawn in year two. Withdrawals from the bond which exceed the 5% allowance create a chargeable event, as does a full encashment of the bond. If a chargeable event occurs, higher-rate taxpayers will have an income tax liability of 20% on the gain. Basic-rate tax payers will have no tax liability and, for those where the gain makes them cross the basic-rate tax threshold, a 20% charge on that part of the gain that falls into the higher-rate band will be made.

Often, the most tax-effective way to hold an investment is in a combination of the above vehicles. Obtaining advice from an IFA is recommended.

Mike Clark is managing director of Johnston Carmichael Financial Services