Take the VCT route to opt out of paying income tax

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Gordon Brown, the chancellor, says that the government's tax and pensions strategy is designed to ensure that everyone pays a fair share of the tax burden and has an equitable opportunity to save for a decent income in retirement.

What he has provided, however, is an opportunity for moderately well off people to use the 2004 Finance Act to opt out of paying both income tax and (after a couple of years) National Insurance contributions.

This is, of course, an approach that is focused on maximising tax breaks rather than on the suitability of investments and their flexibility. It wouldn't be suitable for everyone, but it is going to save a great deal of money for me and for some of my clients.

Here is how it works. Brown has increased the income tax relief on venture capital trust (VCT) investment to allow all taxpayers 40 per cent tax relief on up to £200,000 of investment both this year and next, creating a fund that is then free of capital gains tax (CGT) and of income tax on dividends.

It is true that these are higher risk investments, so it is essential to choose the VCT fund carefully, but there are “asset-backed” VCTs now coming forward that involve only an acceptable capital risk.

The VCT changes coincide neatly with the ending of dividend tax credits on equities held in personal equity plans and individual savings accounts.

So the first step is to move enough capital into VCTs to eliminate income tax, both this year and next. If I pay into a pension fund I can invest only a percentage of my salary with tax relief. But using VCTs I can get back 100 per cent of my tax bill, then sell the shares in three or more years' time tax free, reinvest the net proceeds into a pension fund and so get yet further tax relief on the gross amount.

It gets better. I am 48, so I will be 50 before the Pension ‘A' Day at April 6 2006 (the day on which the “simplification” measures in the 2004 Finance Act take effect).

It looks likely that with careful planning and legal advice, anyone in this age group with a helpful employer will be able to redirect almost all their salary into pension funds after that date (up to a maximum of £215,000 in 2006-07).

If you use a defined contribution pension fund, then you can use instant vesting a process that converts the fund immediately into tax free cash and an annuity to provide a 25 per cent tax-free lump sum plus an annuity income. Or you could use the unsecured income provisions of the Finance Act, which also allow a 25 per cent tax free lump sum, with or without an annual income.

This process can then be repeated each year to release the tax-free cash and to build up either a series of annuities or a deferred unsecured income.

What you will end up with is 25 per cent of your gross salary tax free each year to live on, along with the tax-free VCT investment income.

This option is now open to those in work who are over 47 and have some savings and total income of up to £200,000 (this year). In other words, people in this happy position can opt out of income tax and NICs.

I am an Independent Financial Adviser specialising in this type of advice. My clients and I will benefit substantially from our understanding of the way the changes in the law can be used to minimise tax and increase pensions flexibility. But how does giving all this tax relief to those who already have some savings help those on a low income save for their pensions?

Eventually, the less well-off will have to pay more tax to make up for the amount that the government has chosen not to ask me to pay. This can't be right, just as it can't be right for me to do anything other than leap at the opportunities handed out in the 2004 Budget for myself and to advise my clients accordingly.

James Burgess is a director of Berkeley Burke (Remuneration Consultants).

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