When creating a financial plan, we typically break it down into two key stages:

• Accumulation – building up the wealth base
• Decumulation – drawing down income

By leveraging tax efficient allowances, bands and structures, we can achieve the following outcomes across the two stages:

• accelerate the rate at which savings and investments grow
• limit the burden of tax when accessing the wealth base, thus maximising income

Creating a framework where we allocate and access our capital, tax efficiently, means that underlying investments do not need to work as hard, and long-term objectives are more achievable.

A good place to start is to have a broad understanding on how we are taxed on our income and capital gains in the UK. The below apply to the current 2023/24 tax year.

UK Tax Framework

Income tax 

This is generally relevant to income generated from employment, pensions, properties or investments (unless it’s dividend income).

*60% is the effective rate of tax when you earn over £100,000 because the personal allowance is tapered away by £1, for every £2 over £100,000

Add to this employees national insurance payable on income from employment, which is broadly taxed as follows:

Savings allowance

This relates to interest received on savings, without having to pay tax on it

Dividends tax

Dividends distributed from direct holdings in shares are taxed as follow:

Capital gains tax 

The gains from a sale of an investment, not held in a tax efficient wrapper, are subject to the below tax rates:

The above tables can appear daunting, however, if the planning is done correctly, the more penal tax rates can be avoided and the various tax exempt bands can be leveraged to mitigate the overall tax position.

Accumulation – Building the wealth base

There are a number of structures which allow you to save tax efficiently, predominantly by offering one, or more, of the following features:

• Tax relief on the contributions made into them
• Tax free growth of the underlying investments
• Tax free distributions

Pensions

Pensions offer two key tax advantages in relation to building up retirement savings:

• Tax relief on the contributions made into them
• Tax free investment growth i.e. the returns generated within the pension are not subject to income or capital gains tax

There are limits as to how much can be put into a pension annually, which is £60,000 gross per annum (this is further restricted for those very high earners above £260,000).  However, there is the ability to use up unused allowances from the previous three years, subject to being a member of a pension scheme during those years.

How to make pension contributions?

Salary sacrifice

Employed individuals can give up a proportion of their pay, which the employer pays directly into the pension. The employee benefits from not having paid income tax or national insurance on that money. The employer also benefits from an employer’s national insurance saving, which they may elect to contribute into the pension also.

Contribute personal funds

Alternatively, individuals can contribute personal funds into a pension. Here the pension reclaims 20% basic rate tax relief directly from HMRC. The maximum it can reclaim is based on the higher of:

1. The individuals earned income such as salary or self employed income (investment income such as rent and dividends do not count here), subject to available contribution allowances
2. or £3,600 gross

Example:

If an individual earns £50,000 gross salary per annum, the pension can reclaim 20% of this amount back from HMRC. Therefore, the individual would contribute £40,000 into a pension, which can then reclaim £10,000 from HMRC.

Higher or additional rate tax payers can claim a further 20%/25% via their self assessment tax return.

In respect to those that earn over £100,000, a pension contribution is a great way of clawing back the personal allowance which is otherwise tapered away, and thus saving an effective 60% level of tax.

Non tax payers can pay £2,880 into a pension and it can reclaim £720, to gross the contribution up to £3,600.

Company contributions

Business owners may consider making employer contributions, which generally will save on corporation tax for the business.

Individual Savings Accounts (ISA’s)

Albeit ISA’s do not offer tax relief when putting money into them, they do allow tax free growth within them i.e. the underlying investments are not subject to income tax, dividend tax or capital gains tax.  There is no tax burden when drawing money out of the ISA either.  The most common types of ISA’s are stocks & shares ISA’s and cash ISA’s, into which you can contribute £20,000 per annum.

Single premium bonds

Single premium bonds offer the ability to hold and build up investments with limited or no tax burden. They can be structured as offshore or onshore bonds.

Offshore bonds allow for deferral of tax on the gains, whereby there is little or no tax paid on investment gains within the bond.  This gross roll up effect means investments grow quicker and are unhindered by tax, similar to pensions and ISAs.  Onshore bonds are similar, but the investment gains of the underlying investments are subject to UK life fund taxation, with the tax being deemed to have been paid at basic rate.

Investment bonds offer the ability to draw 5% of the original investment on a ‘tax deferred’ basis, annually. The 5%’s are cumulative, so can be rolled forward if not drawn. The tax deferred nature of the bond means there could be tax to pay at some stage where a “chargeable event” occurs such as; maturity of the investment, full surrender, drawing more than the tax deferred 5%, or death. However, the benefit of this tax deferred capability is that it gives the investor control over when to realise a tax liability e.g. a higher rate tax payer could put off creating a taxable event until they are a basic rate or non-tax payer.

Venture Capital Trusts (VCT’s)

VCT’s are higher risk government approved investments which incentivise investment into small UK companies, by providing valuable tax benefits, such as:

• 30% tax relief on the amount invested subject to holding the investment for 5 years
• Tax free dividends
• Tax free capital gains

For those who have maximised their pension contributions, or have restricted pension contribution allowances, and have the appropriate risk appetite and circumstances, VCT’s could be  valuable investment vehicles to take advantage of, as part of the wider financial planning.

Decumulation – the drawdown

When drawing down income, structuring this efficiently can mean minimising the level of tax paid, and maximising returns on investments.

Sheltering income within tax allowances

Where possible, structure income payments to use up available tax free bands

Pension drawdown

In retirement, 25% of the pension fund can be taken tax free, with the balance being subject to income tax rates.

The tax free cash can be phased, rather than having to draw it all in one go, meaning that it can be drip fed to create a tax free income in retirement, until exhausted.

For every £1 of tax free cash drawn, £3 is designated (or to use the technical term “crystalised”) to pay pension income which is subject to tax.  With the right planning and pension structure, pension benefits could be structured so that for each tranche of money drawn, 25% is tax free, and the balance is subject to income tax rates which fall within unused personal allowances, or kept within the basic rate tax band.

Capital gains tax exemption

Selling down directly held investments which have made gains, and crystalising a gain up to the tax free CGT exemption of £6,000 is a way of using up an often overlooked exemption, and another way of creating a form of a tax free income year after year.

Tax free/deferred income

The ISA’s and VCT’s can distribute tax free income, and the single premium bond a 5% annual tax deferred income.

The below demonstrates what a potential financial plan could look like, where investment capital is allocated to leverage tax efficient structures, allowances and tax bands.

Other factors to consider

• Maximise the allowances of spouses/family members and allocate capital efficiently between the family
• Use it or lose it – if left unused, some of the exemptions/allowances will not be able to be carried forward into future years, so use them whilst you can
• Consider the risks associated with the underlying investments you are going into. Within pensions, ISA’s, direct investments and single premium bonds, investments can be tailored to suit the investor’s risk profile.
• Tax rules are constantly changing, so be mindful of the changing landscape. Diversifying across a wide range of savings vehicles overcomes the risk of relying on one particular strategy and having all of your eggs in one basket

Understanding tax can be complex, but does go a long way in helping build an efficient financial plan, to meet long term financial objectives. If you feel you would benefit from a conversation regarding your needs, please feel free to contact us.

This article is for information purposes and does not constitute advice. It is not intended to be an invitation to buy, or act upon the comments made, and all/any investment decisions should be taken with advice, given appropriate knowledge of the individual’s circumstances. Any forward-looking statement and forecasted returns are for illustrative purposes only and may be subject to change. With respect to invested capital, your capital may be at risk and past performance is not a guide to future returns.