Limited tax relief on pension contributions - where to save now?

wiltshiregirl69

I'm 47 and after 15 years building a business I have got to the position whereby I was able to make good lump sum annual savings into a SIPP. As a start up business I simply didn't have this opportunity until the last few years.

However the rules on tax relief have now changed and my earnings from the business take me over the threshold so I am only able to save £10k each year into the pension and obtain tax relief (and I don't wish to reduce my dividend withdrawal each year to be below the threshold)

I have researched a little and see that VCTs or EIS(??) schemes offer investors tax relief - but are these v risky? I'd like to retire no later than 55. I save the full amount into mine and my husband's ISA each year but only have done so for the last few years - I'm catching up now for early years of fairly frugal living whilst building the business. There might be the opportunity to sell the business and fund retirement that way - but it isn't something I wish to rely on.

Has anyone experience of investing in these tax efficient schemes. I'm not very keen on huge risk as I already hold risk by running a small business.

bowlhead99

On your £10k maximum allowance each year, presumably what you're referring to there is because your annual allowance has tapered down from the standard £40k p.a. due to having an income of over £210k?

You mention you don't want to reduce your divs to get below the threshold. However, depending on your exact numbers, if you're somewhere close to the thresholds it could still be worth giving up some of the income you're currently taking out as dividends, to get below the threshold and take more as pension. Whatever you don't take out from the business as a pension cost, you would be paying your 20% corporation tax on, and then you're paying dividend tax at top rate of 38% on it, which when combined with the corporation tax the business paid when it made the profits, is a pretty massive marginal rate of tax on each £100 earned and paid out via divs, which could be saved if the company gave you a bigger pension.

Obviously if you are already pulling out £300k a year you are not going to be able to get your pension limit up by dropping your divs by £50k or so; but you could consider (for example) taking only a small amount of salary and divs one year (to get the full £40k of tax relief at a high effective rate) and then a massive amount of divs the next year to catch up (only getting the £10k relief), and alternating high / low years in that fashion. At least that way you would be getting over £10k pension relief some years rather than at present where you are only getting £10k relief each and every year.

Anyway to your question on EIS and VCT.

EIS (and SEIS) is inherently riskier thus the more generous allowances for larger amounts of money to be invested that route than VCT. With EIS you are investing in private unlisted early stage businesses which have a business plan and often an exit strategy but might quite feasibly not pay off. There isn't really an exit route other than waiting.

Whereas investing in a new issue of shares in a VCT, it is a simple stockmarket listed investment company just like an investment trust (except it has to follow certain rules on what it can invest in and you have to keep your shares 5 years to be allowed to keep your income tax relief). A VCT might be thinly traded with a large spread, but you can generally take your money back if you are desperate (after taking a valuation hit and giving up the tax relief) because the shares are tradeable. Whereas with EIS it is more of a private arrangement between you and the company and the manager who has arranged the investment for you, and there may not be much of a secondary market.

Claiming income tax relief with a VCT is pretty easy, if you make your investment in the last couple of months of the tax year, you can claim your tax relief in your tax return a few weeks later and get your 30% tax relief back in your hand. Unlike with an EIS where you have to wait around for the company that issued you the shares to eventually commence business and get a certificate from HMRC saying it is all above board before you are allowed to put your relief claim in.

You say you are not very keen on huge rusk but unfortunately the nature of the opportunity is that you do have to be taking bigger risks than 'standard' funds in order for the government to incentivise you with tax breaks without being accused by the EU of offering unfair 'state aid' to the businesses concerned. So there is a list of criteria for the VCT's investment holdings to be seen as qualifying for VCT status, to do with age of underlying investee company, maximum amount invested etc. These rules have tightened up in recent years making the vehicles less flexible in their strategy and opportunities. If the VCTs don't stick to the rules, there is a risk that the status may be taken away, putting your tax break in jeopardy.

At the lower risk end of the scale are funds that really do their damndest not to take risks at all and may deliberately operate with a limited life, aiming to wind up not long after the minimum 5 years have expired to be able to keep the tax relief. For example, they just have you invest 100, but it really only cost you 70 net, so if they can get you back even 90-100 total cash after 5 years you will still be 'up' even though most of your return came from tax relief rather than them actually doing a great job of investing in something profitable. Those sort of limited life schemes don't really interest me as effectively they are just cynically trying to exploit the VCT rules to get free money from the government, rather than having a more noble aim of actually doing good investment deals to invest in innovative young UK businesses.

Personally I would rather be able to say that over 10 years I had got tax relief and made a decent investment return to boot, than say I got tax relief and made a pretty nominal return which was really just the tax relief being paid to me, plus tiny investment returns, less large fees.

Also at the slightly lower risk end of the scale are some VCTs which deliberately invest not in a portfolio of largely unquoted companies, but instead into a portfolio of AIM listed companies - they would be selecting mostly from the listed investee companies which are VCT qualifying, to stay compliant, but ensuring the portfolio is at liquid and the AIM listed nature of the targets means the companies are not always completely unheard of.

The basic risks with that sort of a VCT are similar conceptually to investing in a small microcap-focused fund or investment trust (i.e. you could easily lose 60%+ of the portfolio value in a year on paper; but at least the 5 year lock in encourages you to stick around for a potential recovery).

However there is extra risk on top from a few angles - not just imposed by the investment restrictions they face, meaning they can't pick from everything on the markets, but also the fact that most investors in the VCT do not want to exit in the first 5 years or add much to their holding (not a very liquid market) so you might find it harder to dump your holding and get out if you wanted or needed to do that. As a purchaser of VCT shares your divs are always tax exempt and there is no CGT on gains, but you only get the income tax relief when buying a new issue of shares and not when buying 'second hand'. So there is a gulf in value between what you paid in your subscription and what someone would be willing to pay to take it off your hands as a 'secondary' purchase on the open market a week later.

Other lower risk types of VCT can include those that have a strategy of making qualifying loans and equity investments collateralised on property or asset-heavy businesses. The ones that appear the safest and not really taking investment risks are of course at the highest risk of being disqualified by HMRC who have given a closer look at property or energy-related schemes in recent years.

So, some people will have tales of getting fantastic rates of return from pretty safe-looking VCTs, but the rates of return or the VCT-able-ness of some of the historic deals may not be available these days ; just because someone has a VCT which is paying them high rates of tax-free dividends and has been a solid performer, it doesn't mean that you can go out today and subscribe to a new issue of that same VCT on the same terms.

Overall though, even if you are just looking to invest in some of the generalist VCTs with better track records whose strategies have not had to be rewritten from scratch due to rule changes which came out in the last couple of years... one good thing that you will find is that there are always several available with new issues when you get into the last few months of a tax year, and they often have pretty low minimums (in the context of you having a £200k income) of £3-6k each.

So, with say £40k to invest (only £28k, net of the initial 30% income tax relief), you could easily spread your money across 5-8 opportunities if you were adopting a scattergun approach, and a similar number the following tax year, so, you would not really have your eggs in one basket if one or two went south. I say eggs not in one basket... obviously other than the money in all of them being nearly all invested in early stage UK businesses.... but hopefully not a problem in the context of your wider investment portfolio of S&S ISAs, pension etc.

Personally I wouldn't adopt a scattergun approach - as I would rather buy into three or four or VCTs I like the look of, rather than the next five I don't fancy as much and the five after that which I don't fancy at all, just for the sake of 'spreading it around'.

maximumgardener

you could also fill up your S&S ISA 's each year, if you have not done so already

wiltshiregirl69

Thanks bowlhead - really really helpful reply. I'll look into VCTs and see if I like the look of any. in the meantime your strategy of large div/smaller div years might work well - I hadn't considered that.

TheTracker

I meet lots of other business owners who are excellent at making money, but not many that are excellent at being able to manage money tax effectively both inside and outside the business.

Your business account holding retained profits is effectively a tax wrapper, not just a liability wrapper, because you can defer some tax impact until later years. So in terms of savings you can think of it similar to an ISA or a SIPP with different characteristics.

If you are drawing all your money as dividends, as many small business owners do, it could be for several valid reasons: profit is not so large; You need the cash to live or spend it all per annum; You need the cash to save for a major purchase, like a house; Your company has liability risk (the retained profits are at risk); the profits are so large that even moderate tax law changes would effect retirement planning significantly; you have other shareholders with competing needs; you are of an age that you need to pull the money out.

But quite often I work with colleagues who pull it all out for what I deem invalid reasons: they don't know they can retain profits; they overestimate liability risk; they over estimate risk (impact/likelihood) of tax changes; they like having a big personal balance; they pull it out to put in an ISA.

The last one is the doozy. Instead of leaving it in the business and ultimately paying 10% CGT on it in years to come, they pull it out with 25%+ dividend tax so they can put it in a 0% profit wrapper (ISA). They could leave it in the business and invest in the same vehicles as they would in the ISA. So its a question of weighing the wrappers. Its significant as to how long until you retire, if <10 years perhaps pulling it out to put it in an ISA isn't the best method.

The most tax effective way of pulling money out of a limited company (outside IR35) for a single shareholder/director/employee is to take a salary of £8k and divs of c£30-35k to stay in basic rate tax, and up to £40k in a pension. The only tax you pay is 7.5% on the divs (the company has already paid 20% corporation tax on it). Leave the rest as a warchest, paying 10% CGT when you retire (or whatever the government of the time imposes). Then take any more divs you need to 'live', if any.

You have a husband? Pay him a salary of £8k to do some work for your business and up to £40k pa in pension as long as he stays under the LTA. And/or make him a shareholder and pay those 35k divs to him too. So, a tax effective way of getting £170k pa out of a business. There is a risk of corporate tax changes, so personally I try to have <25% of my wealth in businesses I own.

These are fairly simple calculations and there are plenty of public accountancy websites with the same information, but ask your own accountant to be sure. We haven't heard enough about your personal circumstances to understand which of these strategies could pay dividends (sic) for you.

In my world, I only investigate EIS and VCT *after* all deploying those strategies, as there is little income tax to offset with such vehicles.

wiltshiregirl69

TheTracker wrote: »

I meet lots of other business owners who are excellent at making money, but not many that are excellent at being able to manage money tax effectively both inside and outside the business.

Your business account holding retained profits is effectively a tax wrapper, not just a liability wrapper, because you can defer some tax impact until later years. So in terms of savings you can think of it similar to an ISA or a SIPP with different characteristics.

If you are drawing all your money as dividends, as many small business owners do, it could be for several valid reasons: profit is not so large; You need the cash to live or spend it all per annum; You need the cash to save for a major purchase, like a house; Your company has liability risk (the retained profits are at risk); the profits are so large that even moderate tax law changes would effect retirement planning significantly; you have other shareholders with competing needs; you are of an age that you need to pull the money out.

But quite often I work with colleagues who pull it all out for what I deem invalid reasons: they don't know they can retain profits; they overestimate liability risk; they over estimate risk (impact/likelihood) of tax changes; they like having a big personal balance; they pull it out to put in an ISA.

The last one is the doozy. Instead of leaving it in the business and ultimately paying 10% CGT on it in years to come, they pull it out with 25%+ dividend tax so they can put it in a 0% profit wrapper (ISA). They could leave it in the business and invest in the same vehicles as they would in the ISA. So its a question of weighing the wrappers. Its significant as to how long until you retire, if <10 years perhaps pulling it out to put it in an ISA isn't the best method.

The most tax effective way of pulling money out of a limited company (outside IR35) for a single shareholder/director/employee is to take a salary of £8k and divs of c£30-35k to stay in basic rate tax, and up to £40k in a pension. The only tax you pay is 7.5% on the divs (the company has already paid 20% corporation tax on it). Leave the rest as a warchest, paying 10% CGT when you retire (or whatever the government of the time imposes). Then take any more divs you need to 'live', if any.

You have a husband? Pay him a salary of £8k to do some work for your business and up to £40k pa in pension as long as he stays under the LTA. And/or make him a shareholder and pay those 35k divs to him too. So, a tax effective way of getting £170k pa out of a business. There is a risk of corporate tax changes, so personally I try to have <25% of my wealth in businesses I own.

These are fairly simple calculations and there are plenty of public accountancy websites with the same information, but ask your own accountant to be sure. We haven't heard enough about your personal circumstances to understand which of these strategies could pay dividends (sic) for you.

In my world, I only investigate EIS and VCT *after* all deploying those strategies, as there is little income tax to offset with such vehicles.

Thanks - all good advice. I can't pay my husband a salary as he is working and in the higher tax band. We have fairly high outgoings - so draw out a combined salary and dividend. I already have a large amount saved in the business funding its growth and cashflow. I'm not sure the valuation of the company takes account of retained profits - in the past when I have bought back and sold shares it has been done on a profit multiple.

TheTracker

wiltshiregirl69 wrote: »

Thanks - all good advice. I can't pay my husband a salary as he is working and in the higher tax band. We have fairly high outgoings - so draw out a combined salary and dividend. I already have a large amount saved in the business funding its growth and cashflow. I'm not sure the valuation of the company takes account of retained profits - in the past when I have bought back and sold shares it has been done on a profit multiple.

You draw out £210k+ Per annum personally in salary and dividends? That's what your statement about not being able to contribute more than 10k to a pension implies. Actually, I'm not sure dividend earnings are even relevant to the taper threshold though someone else will pipe up and confirm either way.