Five ways to reduce tax drag on your investments Killik & Co

29 September 2023

Reducing tax drag on investments is critical to ensure investors can realise the full potential of their portfolios throughout the 2023/2024 tax year.

Recent changes in legislation have reduced the amount of gains and income an individual can generate on an investment before paying tax. Two significant changes include the reduction of the tax-free allowance available before Capital Gains Tax (CGT) is payable from £12,300 to £6,000, and the Dividend Allowance from £2,000 to £1,000.

With further changes to tax legislation expected from 6th April 2024, effective tax structuring is becoming even more critical for investors wanting to hold onto the gains made from their investments.

We recently hosted a webinar on tax efficient investing where we shared five ways to reduce tax drag on investments during the 2023/2024 tax year. Read on to learn more about the five options, including utilising ISAs, planning pensions, buying bonds and gilts, investing in a VCT or EIS, and offshore bonds.

Please note: as is the nature with investing, your capital is at risk, and you may not receive back the same amount you put in when you choose to cash out your savings. In addition, the ideas set out in this blog post are based on our current understanding of UK legislation, impacting only those within the UK tax system.

Bronwen Horton

Senior Wealth Planner

Five options

1. Utilise your ISA allowance

The first way investors can reduce tax drag is by taking advantage of an Individual Savings Account (ISA), which allows UK taxpayers to save up to £20,000 per year without paying tax on growth or withdrawals1. Different types of ISAs are available, including a Stocks and Shares ISA, which allows you to hold investments within your savings account and benefit from tax relief on your investments.

Holding investments in an ISA will protect them from Capital Gains Tax (CGT) and income tax, which makes them a compelling vehicle for a long-term investing strategy. In addition, there is usually no tax liability when withdrawing funds.

While £20,000 may initially seem like a small amount, you should not underestimate the impact of compound growth on your funds as any returns gained will grow exponentially over time, and this will be even higher if your investments have generated good returns. However, it is important to note that the value of your investments may rise and fall, and there is no guarantee that you will receive a good return.

2. Plan your pension

Pensions offer another helpful way to reduce tax drag on your investments, and UK taxpayers currently have an Annual Allowance of £60,0002 before tax is payable. In addition, changes to the lifetime allowance announced in the Spring Budget include the removal of some tax charges and lifting allowance thresholds.

While the tax relief offered by pensions is attractive, it is important to note that pension legislation is complex, and we recommend seeking financial advice before making any decisions, especially if you have already begun to draw from your pension. For investors wanting to take more control of their personal pensions and access fully flexible retirement and death benefits, we offer a Self-Invested Personal Pension and can assist with pension consolidation.

Ultimately, the suitability of a pension for reducing tax drag on your investments will depend on your individual financial goals. For example, the recommended structuring of finances for someone seeking to mitigate Inheritance Tax (IHT) may be different to the recommendation we would give someone planning to support their children onto the property ladder.

3. Buy bonds and gilts

Another way to reduce the tax drag on your investments is to buy bonds and gilts, which can be a smart strategy for those looking to diversify their portfolios or needing access to funds for a planned expenditure.

Bonds offer a predictable income and the potential to generate returns on investments, and gilts are one of the most tax-efficient ways you can save and invest today. With no CGT due on any gains made, gilts offer a significant advantage over many investments. Gilts are also seen as a good option for cautious investors, as the government is yet to default on making a coupon payment.

The recent rise of the UK Bank of England Base Rate to 5.25%3 has led to low coupon gilts trading at significant discounts to their maturity value. This provides a compelling opportunity to benefit from the capital uplift of a gilt on maturity, in addition to the interest paid over the rest of the term (the gross redemption yield). Given the return is largely capital uplift, which is tax free, the net yield is much higher than for comparable investments. The table below provides an example of the type of return an investor could expect when comparing the total generated on a gilt to a cash equivalent^.

^This data reflects the price and projected performance of the named gilt on 12th September 2023 and illustrates the potential combined return through the Net Redemption Yield and Cash Equivalent Yield. The actual figures achieved will depend on individual circumstances.

We have recently launched our new Gilt Saver Service, which is designed to help clients buy gilts and is managed by our dedicated Fixed Income team. Find out more here.

4. Consider investing in a VCT or EIS

The options listed above provide some great ways to take advantage of allowances and tax-relief, but investors with a high income tax bill and those who are comfortable taking a higher level of risk may also benefit from investing in a Venture Capital Trust (VCT) or Enterprise Investment Scheme (EIS).

VCTs invest in small, early-stage companies to help them grow. They are structured as a collective investment and tend to take a minority stake of holdings in these companies. There is no guarantee that these companies will succeed, so the government offers attractive tax benefits for investing in them, including 30% income tax relief (received in the year you invest), tax-free dividends, and CGT exemption on disposal. However, you must hold these shares for five years to retain the income tax relief.

The EIS offers a discretionary portfolio that invests in companies at very early stages, and returns come more from capital growth than income. As these companies are very early stage, their timeline for exit for investors is often uncertain, and they are less liquid than a VCT. EIS investments also benefit from the 30% income tax relief upfront and have additional benefits such as CGT deferral and loss relief.

It is important to note that both options are higher risk investments, and you may have liquidity issues. Suitability depends on your individual circumstances, financial goals, and attitude to risk, and these higher-risk strategies should only form a small part of your overall investment portfolio.

5. Consider offshore bonds

Offshore bonds offer another way to reduce the tax-drag on your investments, as they benefit from gross roll-up of income, effectively deferring tax to a time when income received is lower, or even passing it on to a different taxpayer altogether.

In addition to offering the ability to defer tax, offshore bonds allow you to invest in a wide range of assets such as equities, bonds, alternatives and property. You can also change the assets held within your bond over time, which can be especially useful if your financial goals or circumstances change.

Further benefits of offshore bonds include the ability to withdraw capital when you need to without any immediate tax liability (although a rule of 5% of the original value does apply). Finally, they can also be helpful for IHT planning as you can transfer segments or the whole of the bond as a gift without incurring CGT.

More ways we can help with financial planning
While investing can be an effective way to generate returns, there is often a tax liability associated with gains and income derived from investments, which makes it critical to structure your investments in the most tax-efficient* way.

In this blog post, we have outlined five ways that UK investors could reduce tax drag on their investments, from efficient savings vehicles available to all – like ISAs or pensions – to higher-risk investments like VCT. However, we have only provided general guidance, and the actual impact on your financial arrangements will vary based on individual circumstances.

Our Wealth Planning Service may also be able to help identify further opportunities to make the most of your money**. In addition, we offer an integrated Wealth Management service across planning and investing, as we believe working with a Wealth or Financial Planner is the most effective way to make your finances go further on an ongoing basis.

For personalised advice on how to structure your investments efficiently, speak to an Adviser.

* Please note, the tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

** As is the nature with all investing, your capital is at risk and you may not receive back the same amount you put in when you choose to cash out your savings.

1 Individual savings accounts

2 Pension scheme rates

3 Bank of England Bank Rate