Look at that! It’s session number 81, and we’re most definitely going to be taking things up a level and talking about some advanced investing using some very useful tools which most people never even consider. For those bored with pensions and ISAs, or if you have maxed your contributions to these, this session is for you.
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OK, I mentioned briefly in the intro that those who have maxed out their ISA and pension contributions might want to be considering alternatives. As it happens anyone can consider the subject of today’s session, if the circumstances are right.
We’re login to be talking about two tax wrappers which deserve more attention than they get. I know people who don’t save into ISAs at all, and instead invest into Venture Capital Trusts each year. That’s the first of our advanced investments, and the second is Enterprise Investment Schemes also called EISs. VCTs and EISs – these are the subjects of today's session. As usual, we’ll look at what you need to know first, and then look at the practical steps to take – what you need to do – if you think that you might be in a position to make use of these useful tools.
Everything you need to KNOW
So, let's deal with everything you need to know first:
1 – Both the subjects of today’s session are wrappers
Wrappers are tax-boxes. Boxes into which you place money and different kinds of underlying investments. The thing which differentiates one wrapper from another is the tax rules attached to it. So a pension is different from an ISA because its tax rules are different.
Likewise, both VCTs and EISs are wrappers with unique tax rules. Inside these you can place certain investments, which attract valuable tax benefits.
The purpose of both wrappers is to encourage investment in certain sectors of the market by offering tax incentives. Let’s look in detail about how each of them works:
2 – How VCTs Work
Introduced on 6th April 1995, VCTs encourage investors to invest in unlisted companies:
- Unlisted means the shares are either not quoted on any stock market, or
- Or listed on the Alternative Investment Market (AIM) or the iCap Securities and Derivatives Exchange (ISDX) Market
- The companies must carry out a qualifying trade. Most things that companies would do are allowed. Some exclusions are property development, legal/accountancy/financial services and operating nursing homes.
- The companies the VCT invests in must have assets of less than £15million before the VCT invests, and £16million after the investment is made, and they must have fewer than 250 full time employees
- At least 70% of a VCT’s money must be held in companies such as these, the balance can be in other, non-qualifying assets. Finally, a VCT can invest unto 15% of its money into one company.
VCTs have significant tax benefits:
- 30% tax relief up front on an investment up to £200,000. That means on an investment of that size, you get £60,000 of tax relief via your tax return.
- Tax relief is limited to the amount of income tax you have actually paid in the tax year you make the investment
- You have to keep the VCT for five years to retain the tax relief
- No income tax on dividends if any are produced
- Any profit you make on sale of the VCT is Capital Gains Tax free
- You can, after five years, essentially roll over the VCT into a new one, and get income tax relief on the one you have already received tax relief on once.
These are major perks, making it possible to wipe out your income tax bill if you have the means to invest enough money over a five year term.
Does that make these the preserve of the very wealthy? Well, you do have to have sufficient liquid money that you could afford to lock away for five years, in order to get the maximum benefit. But even some tax relief is better than none, so if you have, say, ‘only' £5,000 to put away, you can have £1,500 of tax back, so the investment has only really cost you £3,500.
The five year term might sound restrictive, but bear in mind we would always say that five years is a minimum term for any kind of real-asset investment, and it doesn’t sound so bad. In this case though, the tax relief will be withdrawn on early surrender.
The final benefit is the possibility of serious growth. Smaller companies which are run well can grow spectacularly, rewarding investors with stratospheric returns. The reverse is also true: smaller companies are more likely to go bust, meaning the investors will lose all the money invested in that company.
3 – How EISs work
Introduced in 1994 – more than £1billion was invested in EISs in 2012/13 tax year. Again, unlisted companies are the target investment. Similar to VCT rules, but a couple of differences:
- Investment must be into new shares – can’t buy existing shares
- Investment cannot exceed £5million into any one company in any one year
Tax Benefits – there are five!
- Like VCTs, EISs benefit from Income Tax relief at 30%, but this time up to a £1,000,000 investment, which means £300,000 tax back. I imagine that’ll be out of the reach of most listeners to this. Any millionaires listening to this, do call me! You can also claim back up to £300,000 tax back from the previous year. Again, you have to have paid the tax before you can claim it back!
- Next, EISs benefit from Business Property Relief, which means that after you have held the investment for two years, and if you still hold it on death, then the entire amount is free of Inheritance Tax. That’s a fantastic benefit – you get to retain access to the money if you should need it in the future, but have it free of IHT on death.
- Capital Gains Tax deferral – if you make a taxable gain, you can roll over the gain into an EIS and defer the gain until you encash the EIS one day. If you still own the EIS on death, then the Capital Gain dies with it.
- No Capital Gains Tax on any gains made within the EIS
- Loss relief. Without getting too buried in detail, this means that not only do you get tax free gains, any losses you make can be used to reduce the tax on any gains or against your income tax bill – powerful stuff
The risks are much the same as VCTs in that smaller companies are likely to be much more volatile. Tax rules may also change. That brings us to…
4 – Remember one of our golden rules
Don’t invest in something for tax reasons, which you wouldn’t be happy investing in anyway. As advantageous as VCTs and EISs are, don’t be tempted by the tax breaks if you’re a cautious investor. It simply isn’t worth the lost sleep worrying over the ups and downs.
Even though the tax relief on both these investments essentially builds in a 30% buffer against downside risk, it is possible to lose significantly more than that.
Summary of what you need to KNOW
#1 – Both VCTs and EISs are tax wrappers
#2 – How VCTs work
#3 – How EISs work
#4 – Remember that golden rule not to invest only for tax reasons if the underlying investment is outside your comfort zone
What should you do now if I have piqued your interest in these advanced investing techniques?
Everything you need to DO
1 – Establish your need for investing
VCTs and EISs are generally for those looking to save tax in other areas of their finances, but not exclusively so. As I have mentioned, some people opt for VCTs instead of ISAs, but the access rules and risks are different so this is an exception rather than the rule.
Why are you investing? Is it to grow your money over a long period? Or are you in the run-up to retirement?
I’ve said countless times here that investing should be targeted, and this target timescale, amount, risk tolerance etc will all inform whether or not VCTs and EISs should be a part of that strategy.
2 – Do your research
Like any investment, you need to look into it carefully before parting with your money. Researching VCTs and EISs is not as straightforward as ordinary off-the-shelf funds.
There are some good sites like the Allenbridge Tax Shelter Report for researching these things. This site does earn commission if you invest through them on an execution-only basis, so do be aware of that. Advisers can subscribe to the Allenbridge site and buy their research which is how they make most of their money.
I can’t stress strongly enough that you must know what is going on under the bonnet of these vehicles. Make sure you understand exactly what you are buying for your money. If you can’t then don’t invest. I have had reps for EIS and VCT companies in my office and I have asked them to explain to me what exactly is held at the lowest level of the vehicle and they can’t be unequivocal about it.
Many VCTs and EISs are straightforward enough, investing in AIM shares and the like. Others are designed for capital preservation and it is these ones whitecap be accused of sailing pretty close to the wind I think. The price of the tax breaks is the capital at risk. If you try to get the tax breaks without risking capital, then that smacks of gaming the system, and I’ve never been happy enough with these types of vehicle to put any client money in them.
It should be evident what any particular VCT or EIS is intending to achieve: growth or capital preservation. Either way – know what is under the bonnet.
3 – Make sure the VCT/EIS fits with the rest of your financial planning
It’s a simple point but a good one: Don’t be tempted by the tax breaks and ignore the rest of your financial planning. Investing should always be done in the round, having a mind to the rest of your plans. Don’t just bolt on a VCT or an EIS because the tax breaks sound great.
Remember that once a financial planning target has been identified, you should generally take the least risky route to get there, unless you’re some kind of financial adrenaline junkie. Personally, I like smooth rides, but I do want to get there. EISs and VCTs can accelerate your progress thanks to the tax relief – free money from the government – but they can be a roller coaster ride…
4 – Involve your accountant and/or financial planner
Getting your tax right is fairly important if you want to avoid evasion charges, or at best, interest and fines for getting things wrong. If you’re the sort of person who is likely to invest in EISs or VCTs, chances are you have an accountant. If so, you should definitely involve them in the process. If your accountant doesn’t understand how they work, you should probably get a new accountant.
Likewise a financial planner should be able to talk to you about these specialist investments if they are right for you.
When dealing with advanced investing like this, it is always difficult to know whether a big proportion of the audience will switch off. Let me summarise with an attention grabbing comment then: tax-relief is free money from the government. If that doesn’t at least make you sit up and take notice then I don’t know what will. VCTs and EIS are not the preserve of the mega-wealthy any more, but are increasingly mainstream of rat right kind of person.
Now you know the benefits and understand the risks, I wonder what you’ll do with that information…
This week’s reviews
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Weight loss static at 16st 2lbs. Frustrating. Holiday next week too…
Next Session Announcement
Next time we'll be talking with friend of the show and director of my sponsors Justin Urquhart Stewart. Justin last came on the show back in Session 20. He’ll be answering my questions about the current volatility in the markets and what it all means for investors. If you have a question you’d like me to put to Justin (I’ll be interviewing him on Thursday morning the 23rd October), or if you have any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/askpete
That's it for this session of the MM podcast, I hope it was helpful. If I missed anything or if you have any questions, please leave them comments section below
I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.