Legally avoid income tax
Income tax is paid on most earned income in the UK. The highest rate is 45%, although technically once income exceeds £100,000 you will incur income tax at an effective rate of 60% with the loss of the personal allowance.
Of course you can save tax on savings by using an ISA, but how do you avoid income tax on income from earnings or property?
Tax efficient investments
There are a number of investments that can be used to legally reduce or completely avoid income tax. The one most of us know is of course a pension. But one of the lesser known ones is a Venture Capital Trust (or VCT for short). Below we’ll give you an overview of these two options.
The key points of a VCT are:
- Every £1 invested in a VCT reduces your tax bill by 30p. This means you get 30% tax relief.
- For example, if you have a tax bill of £15,000 an investment of £50,000 into a VCT would cancel out the income tax bill completely.
- Hopefully the VCT will then pay you a tax-free dividend (profit from the underlying assets) whilst you hold it.
- After five years you can cash in the VCT with no tax to pay (and you could then invest that same money in a different VCT and get another lot of tax relief).
- There is no capital gains to pay on a VCT either.
- A contribution to a VCT is effectively a tax reducer (whereas a pension in effect reduces your income and therefore tax).
VCT key information
VCTs are quite different to most investments. But the key point is that anyone who pays UK income tax can use them, provided you can invest your money for at least five years and you’re comfortable with the level of risk. It is worth noting that:
- VCTs have been available since 1995.
- The reason they were introduced was to provide money to invest in smaller businesses. The Government still make them available, because it is hoped that the companies invested in will generate more tax from paying corporation tax, and tax paid by the employees.
- The maximum investment into a VCT is £200,000.
- The companies invested in are relatively small. But many VCTs invest in a wide range of different companies in their VCT which then helps to reduce the risk. Did you know Zoopla, Graze and Secret Escapes were all part funded by VCTs?
- In terms of risk they are a step up from most investment funds.
- There are lots of different VCTs available, and the level of risk can vary quite substantially from provider to provider.
Who can a VCT work for?
The short answer really is anyone who pays UK tax and can afford to take the risk and tie the money up for five years. They can be particularly useful for:
- People who pay high amounts of income tax.
- Business owners with cash in their company. The process is that you declare this cash as a dividend and then invest money into a VCT and reduce the income tax you’ve paid, and then wait five years an take it out.
- High earners whose pension contributions are limited because of a reduced annual allowance.
- People stripping out their pension – money taken out of a pension can be reinvested, and income tax can be reduced or avoided.
- People of any age over 18 can use a VCT. This can be attractive because a pension can only be accessed from age 55 currently (and this is going up to 57 soon).
What are the downsides of a VCT?
It is true that VCTs are a great tool to legally avoiding income tax. But there are some downsides:
- The biggest downside with a VCT is the level of risk. There is a risk that you could get back less than invested.
- They invest in relatively small companies, so this risk is unavoidable, but arguably every £100,000 invested has only cost you £70,000.
- Some may only invest in a narrow range of companies, and others a much wider range thereby reducing the risk.
- You have to be able to hold it for at least five years. If you cash it in early you would have to pay the tax savings back (although dividends would not be taxable).
- The VCT may not pay any dividends during the term.
- They are not very liquid – this means that they are not always easy to sell to get you money out. (This might have to be time with the providers new issue, which can be twice each year).
VCTs are not right for everyone. But without doubt they can reduce your tax bill, and if you continue to build them up over a number of years, you can encash one every five years and reinvest into a different VCT and have a lifetime series of tax reducers.
If you want to know more then contact us online or phone on 01793 686393. If you want to read more then more on VCTS
Pension contributions are also a great way to legally avoid paying income tax. The key points are:
- You need to have earned income to pay into a pension and Investment income, rental income and dividends do not count.
- Contributions receive tax relief at your highest marginal rate. This means that if for example you pay 40% tax, some (or all) of your contribution will save you 40p in tax for every £1 you invest.
- You can pay in up to your earnings or a maximum of £60,000 per year.
- Depending on your circumstances you can pay in more than the £60,000 cap using “carry forward”.
- Any growth in the pension fund is not subject to income tax or capital gains tax. It is usually exempt from inheritance tax too.
- Employers can make contributions on your behalf. This can be useful for business owners, as it could avoid corporation tax on company profits.
- When you come to take benefits 25% of the fund can be taken tax-free (subject to a cap of 25% of the lifetime allowance).
- Your pension pot is no longer restricted by the lifetime allowance – but the tax-free cash is.
- You would need to be at least 55 to take benefits, although this will be increasing to 57 soon.
- Pension investments can be very low risk or very high risk. The choice is yours.
The tax-relief position is more complicated with a pension than with the VCT. If you paid all of your earnings into a pension, then you could for example get some tax relief at 40%, and some at 20%. But it is an income reducer, which can help reduce your income if it exceeds £100,000 or affects the child benefits because your income is over £50,000.
We also have our own legally avoiding tax website where you can find out more about VCTs and pensions. Click the link to www.avoidtaxlegally.co.uk.
Pensions - tax deferred or tax avoided?
It is true that when you pay money into a pension you can reduce your income tax bill. But, when you come to take money out, other than the tax-free cash, the rest is subject to income tax. So, do you actually avoid tax with a pension or just delay it? A few worked example may help explain this:
40% tax payer contribution
Suppose you have earnings that of just over £60,000 per year. You would have around £10,000 of your income taxed at 40%. So you have a choice, you can pay around £10,000 into a pension and have £10,000 invested in a pension or have it paid to you and taxed, and effectively receive an extra £6,000 in your pocket.
So, on the face of it it is a 40% tax saving if you pay it into a pension. But when you come to take benefits, how much you save will depend on your other income. Below are a few examples (and they do not include any investment growth).
20% tax payer – at retirement
Suppose at retirement you are a 20% tax payer, and you took the £10,000 out of the pension and this did not take you into the 40% tax bracket. You would get:
£7,500 taxed at 20% (£1,500)
£8,500 net amount received
So here there is a tax saving. You could have had £6,000 paid to you when working, but by using a pension you have received £8,500 and effectively saved yourself £2,500 in tax.
40% tax payer – at retirement
Suppose at retirement you are a 40% tax payer, and you took the £10,000 out of the pension and this did not take your income over £100,000. You would get:
£7,500 taxed at 40% (£3,000)
£7,000 net amount received
So, when you made the contribution you could have received £6,000 on the £10,000 that incurred tax at 40% tax. But, (ignoring investment growth), you have only saved yourself £1,000 in income tax.
These are just two very simple examples of the potential tax situation on pensions. It does not factor in employer contributions, growth or personal circumstances. And of course the first £12,500 of income is normally tax-free. But the key point is that pensions can save you tax on money invested, but there are implications if you take the money out.
If you want to discuss any of the issues or want advice, have a question, or just want to have a chat about it with a UK Qualified Independent Financial Adviser, then phone now on 01793 686393 or contact us online.