Tax-free wrapper investments allow individuals to receive tax benefits on their investments. Thus, tax-free wrapper investments help investors invest tax efficiently and save some or all of the taxes paid on their investments.
Tax-free wrapper investments in the UK allow the invested money to remain sheltered and grow without any capital gains taxes. Additionally, the income generated from such investments is also free from income tax. Instead of losing your hard-earned money in taxes, it is a clever decision to invest in tax-free wrappers so that your money keeps growing without taxes eating into the growth and income.
The most common and beneficial tax-free wrappers in the UK include ISAs, pension schemes, and venture capital schemes. Here, we take a look at these tax wrappers in detail to understand their advantages and limitations.
Individual Savings (ISAs)
ISAs work as excellent tax wrappers for individuals in the UK. They offer flexibility, tax efficiency, and growth to the investors. Investors do not receive much tax relief on the contributions made towards ISAs; however, the growth and income from them are tax-free. The withdrawals from ISAs are also tax-free, making them ideal tax-free wrapper investments.
Investors can put up to £20,000 per year into their ISAs and receive a tax benefit on the contributed amount. This is called the annual allowance. The annual allowance can be invested in online cash ISAs, online stocks and shares ISAs, or a combination of both. The amount saved in cash ISAs can also be transferred to stocks and shares ISAs and vice versa. Thus, savers in the UK enjoy tax benefits on the contributions made towards their ISAs. Moreover, there is no capital gains tax on the investment, no income tax on the income generated, and tax-free withdrawals.
In addition to the cash and stocks and shares ISAs, you can also save in Junior ISAs on behalf of your children under the age of 18. The contributions up to £9,000 per year are tax-free, and so are the returns earned on the investment.
Additionally, Innovative Finance ISAs allow savers to invest in crowdfunding schemes and other innovative finance instruments while still enjoying the tax benefits provided by the traditional ISAs. The last type of ISA, Lifetime ISA, allows individuals in the UK to save up to £4,000 per year tax-free and withdraw the money at the time of retirement. The withdrawals from Lifetime ISAs, unlike pensions, are also tax-free.
The next most efficient tax wrapper investment is pension schemes. The UK individuals can contribute the lower of 100% of their income or £40,000 per year towards their pension schemes and get tax relief on the contributions. The annual allowance tapers down as the net income increases, with a reduction of £1 for every £2 above £150,000. Any contributions made towards pensions within the annual allowance limit are tax-free.
In addition to the tax-free contributions, the invested money is also allowed to grow tax-free. There is no capital gains tax and no income tax. The tax reliefs are to such an effect that a £100 contribution to pensions costs only £80 to a basic rate taxpayer and only £55 to an additional rate taxpayer. The government tops up the remaining amount in the form of income tax refunds.
However, pensions are not as tax-efficient as ISAs in terms of withdrawal. The first 25% lump-sum withdrawal is tax-free; however, any further withdrawal in the form of drawdown or annuities is taxed like ordinary income.
SIPPs or Self-Invested Personal Pensions offer the same benefits as other pension schemes, but with the additional flexibility of investing in assets and securities of your choice. Individuals can place their contributions in assets like equities, derivatives, or gold, and receive tax benefits through the tax wrapper.
Venture Capital Schemes
The UK government offers attractive tax benefits for investing in early-stage companies listed on the London Stock Exchange. Such investment companies are called Venture Capital Trusts (VCTs) and are encouraged by the government. The UK government offers tax benefits on such investments to promote investments in early-stage and small companies, despite them being risky and long-term investments. Investors get a 30% tax relief on investments up to £200,000 in VCTs. Additionally, there is no capital gains tax on selling the VCT shares and no income tax on dividends received on VCT shares.
The government also offers additional tax benefits through venture capital schemes, like EIS and SEIS. Enterprise Investment Scheme (EIS) supports the unlisted early-stage businesses and promotes investors to invest in them by providing lucrative tax benefits. Investments made in these unlisted and risky ventures provide 30% income tax relief on the value of the total investment to investors, along with capital gains tax deferral. Moreover, if the investment in these companies does not generate returns, the net invested amount is also eligible for loss relief.
Similarly, investments in some early-stage businesses under the Seed Enterprise Investment Scheme (SEIS) provides investors with a 50% tax relief on income tax and a 50% relief on reinvested profits. The total exposure of investing in early-stage companies reduces to just about 13.5% with the help of tax benefits offered under the SEIS.
As a bottom line, it is critical for investors and savers in the UK to pick their investments wisely. They must ensure that they make optimum use of tax benefits offered by the government to reduce the taxes paid, increase their income, and diversify to make the most of their investments. Investors can choose the most suitable tax-free wrappers based on their financial goals, risk tolerance, and personal finances.