Tax an easy to understand guide 2011/12

Setting aside income in the form of savings is important for us all, to provide for the unexpected or to build up a nest egg that we can enjoy in retirement. Given that the earnings from which our savings come have already been taxed, people often object to the fact that any return they enjoy on their investments will usually be taxed again.

In this section we consider what are the most tax efficient investments to make.

Pensions

Pensions are one of the most tax efficient forms of saving. A higher rate taxpayer can contribute £100 to a registered pension fund at a cost of only £60 and investment income and capital gains will accrue within the scheme largely tax free. For additional rate taxpayers the savings are even higher with a £100 contribution effectively costing £50.

An individual is entitled to tax relief on personal contributions in any given tax year up to the higher of 100% of earned income or £3,600 (gross).

The contributions are paid net of basic rate tax and the pension provider will then recover that basic rate tax from HMRC. Higher and additional rate relief, if appropriate, can be claimed from HMRC. Contributions in excess of the individual’s limit can be made into a scheme but the excess will not attract tax relief.

An employer may make contributions to a scheme and a deduction from profits may be available to the employer.

As these reliefs are generous, there are controls which serve to limit high levels of contribution. These are complex but, put simply, they will give rise to a tax charge if annual contributions result in an increase in pension rights for a year of more than £50,000 (for 2011/12) or if the value of the fund when benefits are taken is greater than a lifetime allowance which, for 2011/12, is £1.8 million.

Various options are available on and throughout retirement with regard to taking pension entitlement. The most common being to take part of the fund, normally 25% as a tax free lump sum and the balance is then used to buy a taxable life annuity.

Tax free savings

Individual Savings Accounts (ISAs)

ISAs are free of income tax and capital gains tax. There are maximum investment limits which apply for each tax year but, over several years, large investments can be built up. The ISA can be in stocks and shares or cash but most ISA providers invest solely in stocks and shares. Banks and building societies provide cash ISAs.

Other tax efficient investments

The following investments work in varying ways. You should consider your needs in detail before entering into any commitments.

National Savings and Investment (NS&I)

There are a number of products, taxed in different ways, but some, such as savings certificates, are tax free.

Premium bonds

However, the annual rate of return is a lottery. The more you invest (maximum £30,000) the more frequently you are likely to win, the smaller prizes at least. However, there is no guarantee of a steady rate of return and other savings vehicles may be more suitable.

Practical Tip

Interest paid to individuals by banks and building societies will have tax deducted at 20%. If you do not pay tax you can sign a form to have the interest paid gross. If you have suffered tax but are not liable for it, you can make a repayment claim.

Single premium insurance bonds

These provide a means of deferring income into a subsequent period when it may be taxed at a lower rate.

The Enterprise Investment Scheme (EIS)

Income tax relief at 30% (subject to State aid approval) is available on new equity investment (in qualifying unquoted trading companies) of up to £500,000 in 2011/12. A capital gains tax exemption may be given on sales of EIS shares held for at least three years. If the proceeds realised on the sale of any chargeable asset (eg quoted shares, second homes, etc) are reinvested in EIS shares, the gain on the disposal can be deferred.

Tax Planning

It is also possible to obtain income tax relief in the previous tax year for qualifying purchases. Shares acquired up to the annual limit of £500,000 at any time in the current tax year may be carried back for tax relief. This may be beneficial where tax relief would otherwise not be obtained due to a low current tax year liability.

Venture Capital Trusts (VCT)

These bodies invest in the shares of unquoted trading companies. An investor in the shares of a VCT will be exempt from tax on dividends and on any capital gain arising from disposal of the shares in the VCT. Income tax relief currently at 30% is available on subscriptions for VCT shares, up to £200,000 per tax year, so long as the shares are held for at least five years.

Tax and your investments