ROBERTSONS & CRAWFORD LTD
Independent Financial Advisers
Investments - What is an investment really?
What Are Investments and Pensions?
There is often much confusion surrounding various types of investment in the UK – “I don’t understand Pensions, they don’t perform very well do they?” “ISA’s, not much growth there!” or “Stocks and Shares ISA’s; aren’t they risky?” and so on, but the reality is that most investments are virtually the same; it’s essentially just the way they are treated for tax by HMRC that differs.
To put things into perspective, imagine an investment (any type of investment – ISA, Pension etc.) is a gift box and the box is wrapped in wrapping paper. Depending on the type of gift, the box may have different kinds of wrapping paper. For instance, a birthday present would be wrapped in paper saying “Happy Birthday!” and likewise a Christmas present wrapped in paper covered in pictures of snow covered villages. These wrappers define the occasion and therefore, to some degree, the contents of the box.
The boxes all do the same job, they all contain a gift and they are all wrapped in paper – so they’re all pretty much the same thing, each just have a couple of little differences.
Investments are the same but the way they are treated for tax is called the ‘tax wrapper’. Many people have heard the term ‘Wrap’ in conversations around investments but were unsure as to exactly what that meant; it means the Tax Wrapper.
So, what you invest in is the ‘box’, the way it is treated for tax (the difference in investment) is the ‘wrapper’ and the part that actually makes you money, through interest or growth etc. is the ‘gift’ or the underlying investment portfolio. In the majority of cases in retail investments (investments that the majority of us buy), the underlying investment portfolio is generally made up of a number of Unit Trust Funds.
When you deal with a Financial Adviser, they will guide you, based on a number of principals and personal criteria, in how best to invest your money to provide you with the most tax efficient investment vehicle for your chosen purpose. They may recommend an ISA, a Unit Trust fund, a Pension plan, Bond but what you need to remember is they are all very similar in how they work; they are just treated differently for tax.
No one investment is more risky than another. A pension is no more risky than a Unit Trust; an ISA is no more risky than a pension or a bond. What does make a difference to the level of risk is the make-up of the underlying portfolio of funds contained in each investment wrapper. This is where a good Independent Financial Advisor can help and guide you in choosing an underlying investment portfolio that suits your specific needs. There is no ‘One Size Fits All’ approach to investing as no two people are the same and no two situations are the same. So what may be great for your next door neighbour or your cousin may not be remotely relevant to you personally.
What is a Personal Pension Plan?
Personal Pension Plans (PPP) - have now been around since mid 1988. They were introduced by the UK government to enable the self employed and employees working for companies not operating a group pension scheme to build up a pension fund for retirement.
PPP’s are ‘money purchase’ schemes with contributions receiving tax relief. An employer may contribute to an individual’s PPP and PPP’s can move with an individual when the change jobs.
Eligibility - To be eligible to invest in a PPP and receive tax relief on personal contributions, an individual investor must be under the age of 75 and a resident in the UK (there are some exemptions for individuals who work for the UK government or have left the UK in the last few years).
Contributions can also be made by your employer or a third party i.e. a parent or spouse.
The minimum contribution will vary between providers but is usually around £60.00 per month, contributions can be stopped at any time.
Given the many tax advantages that are available with regard to funding a personal pension there are limits to the tax relievable contributions that can be paid. Individuals are able to make contributions up to the greater of £3,600 or 100% of their annual earnings to all of their pensions each tax year and receive tax relief on them.
There is an annual limit on the total amount of pension contributions (this includes employer and employee contributions). This is called the Annual Allowance. Where the total employer and/or individual contributions exceed the Annual Allowance, a tax charge will apply. Depending on your taxable income the excess in savings charge pension savings can be taxed in whole or in part at the rates of 45%, 40% or 20%. For the 2016/17 tax year the Annual Allowance has been set at £40,000 however, it may be possible to contribute amounts in excess of the Annual Allowance in some circumstances under the rules which allow unused Annual Allowance from the previous three tax years to be ‘carried forward’ and added to the current year’s Annual Allowance.
From the 6th of April 2016, individuals who have an adjusted income (income plus employer pension contributions) for a tax year greater that £150,000 will have their Annual Allowance for that year restricted. It will be reduced by £1 for every £2 of income earned over the £150,000 threshold.
The maximum reduction will be £30,000, so anyone with an income of £210,000 or more will only have an Annual Allowance of £10,000. High income individuals caught by the restriction may therefore have to reduce the contributions paid by them and/or their employer, or suffer an Annual Allowance tax charge. The tapered reduction won’t apply to anyone with a threshold income (income less personal pension contributions) of less than £110,000.
Taxation - Contributions to Personal Pensions generate direct tax savings. Contributions made are net of basic rate tax relief, which means that you will only actually contribute £80 net for every £100 of contribution made. Higher rate and additional rate taxpayers likewise make contributions net of basic rate of tax and can claim additional relief via their inspector of taxes/Self-Assessment return.
A 40% tax payer therefore only contributes £60 for every £100 of contributions falling within the higher rate band. A 45% taxpayer only contributes £55 for every £100 of contributions falling within the additional rate band. These figures assume basic rate of tax at 20%, higher rate tax at 40% and additional rate tax at 45% (2016/17).
Your pension contributions, once made, will be invested in funds where there is no liability to Capital Gains tax and where all forms of investment income are also tax free. Your money may therefore grow faster in a Personal Pension than in most other forms of investment.
An employer is able to contribute and receive corporation tax relief and any amount their local inspector of taxes is satisfied meets the “wholly and exclusively for the purposes of business” test.
All statements concerning the tax treatment of products and their benefits are based on our understanding of the current tax laws and HMRC practise. Levels and basis of tax relief are subject to change.
Withdrawals - The earliest you can access your pension benefits is age 55. This minimum age is expected to increase to 57 from 2028 as the state pension age increases.
At retirement you have the option to take up to 25% of your fund as a tax free cash lump sum; the remaining 75% will be taxed as income, when drawn, at your marginal rate(s) of income tax.
There is now no upper age limit by which retirement benefits must be taken.
There are no restrictions on a person’s ability to draw down from their defined contribution pension pots after age 55, this will allow flexible access to your pension savings.
This also means there is no particular product you must purchase or invest in when accessing your savings, it will be up to you to decide how to access them, either as a lump sum or through some sort of financial product such as an annuity.
If the total value of your pension benefits exceed the “Lifetime Allowance”, the excess benefits will be subject to a tax charge of 55% of the amount over the Lifetime Allowance threshold. For 2016/17 this has been set at £1,000,000 but it may be possible to keep a higher limit should one of the forms of ‘protection’ are applied for:
• Individual Protection 2016 (IP2016) – available to those whose total pension benefits were greater than £1 million on the 5th April 2016 and will allow those individuals meeting certain criteria to fix their Lifetime Allowance at the value of their pension savings as at 5th April 2016, with the maximum protection being £1.25 million. Funding can continue but further funding is likely to be subject to the 55% tax charge.
• Fixed Protection 2016 (FP2016) – doesn’t require a minimum fund value but is aimed at those who expect their fund values to be in excess of £1 million at retirement. It fixes the individuals lifetime allowance at £1.25 million but doesn’t allow any further pension contributions.
Payment on Death - The value of your pension fund is available to your beneficiaries on your death and can normally be withdrawn as a lump sum or left within the pension wrapper to be drawn on to provide a regular or ad-hoc income. Should you die before the age of 75, these benefits will normally be paid to your beneficiaries, either as a lump sum or income, free of any tax. If you die after the age of 75 the benefits drawn will be taxed as income.
What is an ISA?
The Individual Savings Account (ISA) - Individual Savings Accounts (ISAs) are a popular and simple way to save and you don't pay any personal income tax or capital gains tax on any profit you may make. Any dividends you receive are paid net, with a 10% tax credit. There is no further tax liability.
Individual Savings Accounts were introduced by the government in April 1999 to replace Personal Equity Plans (PEPs) and Tax Exempt Special Savings Accounts (TESSAs) as a tax-efficient way to encourage people to save over the medium- to long-term. Because they offer greater tax-efficiency that, say, a Unit Trust, their use is limited in each tax year to an allowance.
The annual investment allowance is £20,000 in this tax year. The whole allowance is available to split between Investment ISAs and Cash ISAs and the funds can be moved in either direction between these two types of account at any time. You have advised me that you have not used any part of your ISA allowance in the current tax year, which means you retain an allowance of up to £15,240 in any form of ISA. We are also advised that this limit will remain the same for the 2016-2017 tax year starting on the 6th of April 2016.
Cash ISA’s vs Stocks & Shares ISA’s - There is often a little confusion about the difference between a Cash ISA and a Stocks & Shares ISA. Firstly, when one talks about an ISA the majority of people think about a cash ISA, something g issued by a bank or other financial institution that provides a fixed amount of interest over a certain period. Like bank savings accounts this is generally a very low amount of interest but the advantage is that the interest earned is tax free.
Investment ISA’s, or Stocks and Shares ISA’s are best viewed as long-term investments (five years or more), but you can have access to your money whenever you need to.
Many ISAs are actually built on underlying Unit Trusts – or OEICs - that have additional tax concessions
Advantages of an ISA:
• No tax paid on income or growth (save a non-refundable 10% tax on dividends earned).
• Instant access to Stock and Shares holdings or cash (assuming no fixed investment term).
• Cash ISAs protect the capital invested.
• No restrictions on the size of withdrawals.
• Although you are a taxpayer you will pay at most 10% on dividend payments made within your investment.
Disadvantages of an ISA:
• Stocks and Shares ISAs are investment risk bearing and you may get back less than you invested
• Stocks and Shares ISAs are considered investments for the medium to longer term.
• All ISAs are limited to the prevailing annual investment allowance.
• Cash ISA interest rates are currently low, running below present inflation rates and thereby diminishing the buying power of your monies over its investment term.
What is a Unit Trust Fund?
The Unit Trust - or OEIC - If you have used your annual ISA allowance, Unit Trusts and Open-Ended Investment Companies (OEICs) are a good way for smaller investors to enjoy the power of big institutional investors, putting their money into a variety of assets that could offset some of the risk.
Your money is put into a fund, along with money from other investors. This pooled fund is then invested across many different investments by a fund manager. The fund manager looks after the money in the fund, making regular adjustments depending on the performance of individual holdings, market conditions and the fund's objective.
Unit Trusts and OEICs are best viewed as long-term investments (five years or more), but you can access your money whenever you need to.
Advantages of investing in funds through a Unit Trust:
• Allows for diversification within your holding.
• Your unit price is aligned with the net asset value of the fund’s holding.
• The relevant fund manager tries to maximise your return.
• No capital gains tax is payable on gains made by investments held within the fund.
• Capital gains tax may be payable when you sell your units; however, and you're required to detail this in your self-assessment tax return.
• You each have a personal capital gains tax allowance ( that can help you limit any potential tax liability. Since 23 June 2010 the rate of tax that applies on any gain over your allowance is either 18% or 28% depending on your taxable income level.
• Due to the new rules on dividends introduced as from April 2016, you can hold quite a large number of shares in units in unit trusts without breaching the £5,000 Dividend Allowance
• Where you do not necessarily need a regular income and your withdrawals can be made irregularly, these withdrawals would be assessed against your capital gains tax allowance. This needs careful management to ensure stay within your allowances.
• In each new tax year you can switch your investment from your Unit Trust to your ISA using their new annual ISA allowance.
• Buying and selling is relatively easy.
Disadvantages of investing in funds through a Unit Trust:
• Unit Trusts are not allowed to borrow, therefore reducing potential returns.
• Inflow/outflow pressures
• Buying and selling can only occur at certain times of the day
• Fund managers can make a bad bet and lose money for investors
• Not suited for short term investments, i.e. less than five years and risk adverse investors.