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March 13, 2009 6:00 pm
Gordon Brown this week signalled that the Budget, due on April 22, is likely to include measures to make tax-free individual savings accounts (Isas) more attractive, following recent interest rate cuts.
But the prospect of improved Isa incentives – perhaps through increasing the £7,200 annual limit – should not deter investors from using their allowances in the current tax year ending on April 5, advisers say.
With government finances stretched and taxes set to rise in the longer term, investors should “use tax reliefs where they can”, according to Tom McPhail of Hargreaves Lansdown, an advice and self-invested personal pension (Sipp) firm.
He notes that individuals could have contributed nearly £200,000 to Isas and their Pep predecessors over the past 20 years. As well as sheltering subsequent investment profits from tax, such amounts in Isas could now be delivering a tax-free income of thousands of pounds a year.
Andrew Gadd, head of research at Lighthouse Group, an adviser network, adds that Isas and other tax shelters such as low-cost Sipps are “very cheap insurance” against future tax increases.
Even investors put off Isas by stock market turmoil should use this year’s allowance to ringfence existing portfolio holdings from tax through “bed and Isa” transactions, suggests Adrian Lowcock, senior investment adviser at Bestinvest.
These involve selling an investment held outside the Isa, then buying it back within the plan – so sheltering future returns from tax. With share prices relatively low, investors could also crystallise losses which can be used to cut future capital gains tax bills on other holdings. Another attraction of “bed and Isa-ing” is that investors do not need to commit more cash to use up their allowances.
Alternatively, with many stocks and shares Isas, cautious investors can keep
contributions in cash until they are comfortable putting their money into the markets. However, interest on these deposits tends to be very low, even by current standards.
Even so, the uncertain economic backdrop may make Isas seem preferable to contributing to a pension, say experts. Pension monies are tied up until retirement, whereas Isas do not have this restriction. But the upfront income tax relief of 40 per cent still makes pensions particularly attractive for higher rate taxpayers (see below).
Instead of paying tax at 40 per cent, some high earners could wipe out their higher rate tax (HRT) liability for 2008/9 by making extra contributions before April 5. “We see people contributing everything they can afford over the [HRT] threshold,” says Lowcock.
For every £1,000 earned over this limit – £40,835 in 2008/9 – a net contribution of £800 into a personal pension such as Sipp or low-cost stakeholder plan will cut an HRT liability by £200. In addition, a further £200 of basic rate tax relief is given through the pension – boosting the contribution to £1,000.
Higher rate taxpayers can claim their extra relief through their tax returns – although with workplace additional voluntary contribution (AVC) plans, the full 40 per cent tax relief may be given automatically.
Some high earners are able to cut their income tax bills by many thousands of pounds. And by transferring holdings into Sipps via “bed and Sipp-ing”, investors can cut their tax bills and boost their pensions without locking away cash.
The generous upfront tax relief for higher rate taxpayers has prompted speculation that it may be scrapped – hence advice that investors should take advantage while they can. While many experts regard its outright removal as unlikely, they note there could be scope for restricting the relief.
Gadd says: “I’ve always been surprised [the tax breaks] are so generous. The aim of higher rate tax relief is to boost retirement savings but [with personal pensions] this is actually paid out [as a tax rebate or as a reduced bill].”
The rules could be changed so that the full 40 per cent tax relief is reclaimed within personal pensions to boost their value, he suggests.
Another possible restriction could be lowering the limit for contributions on which relief could be claimed to £100,000 a year. Currently, tax relief is available on contributions up to £235,000 a year, subject to individuals having sufficient earnings from employment.
How to wipe out higher rate tax by contributing to a pension:
● Earnings: £50,835
● Higher rate tax (HRT) threshold: £40,835
● So £10,000* of earnings is liable to 40 per cent tax (ie £4,000).
● Contribute £8,000 (net of tax) to, for example, a Sipp or personal pension
● Contribution is grossed up in pension to £10,000 by basic rate tax relief of £2,000 (20 per cent of gross contribution)
● Claim a further £2,000 tax relief through your tax return (ie the additional 20 per cent tax that you would otherwise pay).
●Net cost of a £10,000 pension contribution to a higher rate taxpayer is therefore £6,000.
Source: Hargreaves Lansdown
* This does not take into account any HRT relief from existing workplace pension contributions
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