Investing beyond pensions and ISAs

A client has money to invest but they have already made their pension contributions and used up their ISA allowance. So, what should they do next? Venture Capital Trusts and the Enterprise Investment Scheme are options but I’m not going to cover those here. I’m going to consider the traditional wrappers typically found on an investment platform – collectives, onshore bonds and offshore bonds.

The first thing to say is that a client shouldn’t snooker themselves given pension and ISA allowances are so valuable. Everyone under the age of 75 can pay between £3,600 and £60,000 each year into a pension and receive tax relief. They also have an annual ISA allowance of £20,000 (ignoring the planned ‘British’ ISA). This means, over a five-year period, a couple could have between £236,000 and £800,000 of allowances between them. So, whatever a client’s plans are for their money beyond a pension and ISA, they will probably want to make sure they have enough assets to fund these wrappers going forwards. But assuming that has been accounted for, what should they do next?

The tax conundrum

This is something of a puzzle – it isn’t as simple as a bond versus a collective. This is because investment returns are generally broken down into three different types of return – capital gains, dividends and interest – and these are potentially all taxed at different rates with potentially different allowances:

• Onshore bonds: as a default, some tax will be deducted from the investment as the client goes along and there will be a final tax assessment on the chargeable event to see if additional tax is due
• Offshore bonds: these roll up gross with the gain assessed to tax on a chargeable event
• Collectives: tax will be due as the client goes along while capital gains will be assessed at the end of the investment.

So, a lot will be dependent on the rate of tax the client pays along the way as well as the rate they pay at the end of the investment. 

I am often asked whether the reduction to the capital gains allowance means that collectives are now less attractive. My answer to this is very firmly ‘no’. This is because, unless the client will be a non-taxpayer on the way out (in which case an offshore bond looks attractive), the client will pay the lowest amount of tax within a collective when you consider capital gains. The top rate of tax for capital gains within a collective is 20% – this is the same as the rate of tax that will be deducted from capital gains on an ongoing basis within an onshore bond. And remember, there’s also an annual exemption allowance for capital gains that can be utilised through a collective which is £3,000 for the 2024/25 tax year. So, collectives look the best when it comes to capital gains.

However, it’s a different story with dividends. These work very well within an onshore bond – the client doesn’t pay any tax on an ongoing basis and they get a credit as though they have paid basic-rate tax. Collectives still work very well for non and basic-rate taxpayers, especially as the £500 (for 2024/25) annual dividend allowance can be utilised, but it starts to get more expensive for higher and additional-rate taxpayers.

Then we’ve got interest. Collectives work very well for basic and non-taxpayers, as there will be the full £1,000 personal savings allowance and potentially also the starting rate for savings. Where clients pay additional or higher rates of tax, the results across the wrappers are very similar

Comparing the options

So, this is the conundrum – what is best is really going to be dependent on individual client circumstances. The important consideration – after the client has made their pension and ISA contributions – is what is the most tax-efficient way of holding the investment? The chart below shows the best solution for the three different investment options assuming no withdrawals are made. The investment sum is shown on the vertical axis while the client’s rate of tax during the investment and at the end of the investment is shown on the horizontal axis.

Comparing the options – no withdrawals

6% total return ~ 2.5% Capital Growth / 2% Dividend / 1.5% Interest – No withdrawals – 10 year investment – Compound effective tax

AEA of £3,000 used each year. Dividend allowance of £500. Savings allowance £1,000, £500, or £0 (BRT/HRT/ADRT)

Firstly, if you look at the three columns on the right, this is where the client is a non-taxpayer at the end of the investment (Nb. you need to scroll across to uncover the right-hand side of the chart). As I mentioned earlier, this is where an offshore bond does well, although it is fair to say that relatively few clients will end up in this position. In this analysis, I’m therefore going to concentrate on where the client is a taxpayer on the way out.

Let’s start with those clients who are basic-rate taxpayers both during and at the end of the investment. This shows quite firmly that collectives deliver the best result. Even where £500,000 is invested, there’s still an advantage of holding it within a collective. Providing the ongoing dividends and interest keep the client within the basic rate threshold, they are going to be best off within a collective. If they are a higher or additional-rate taxpayer during the investment but a basic-rate taxpayer on the way out, then onshore bonds work very well. If the client is going to pay higher or additional rate tax on the way out, then collectives begin to look good again.

So, the important consideration is, what is the most tax-efficient way of holding the investment for the client? If you’re advising a couple paying different tax rates – one’s a higher-rate taxpayer, for example, and the other is a basic-rate taxpayer – then the least amount of tax will be paid if the assets are held within a collective in the basic rate taxpayer’s name. This is why it’s not bonds versus collectives – it’s about what the client circumstances are and the most effective way of holding the money in terms of the tax rates that are going to be paid and then selecting the most appropriate wrapper for those circumstances.

Before I move on, I also want to cover where withdrawals are taken from the investment and this is shown in the table below.

Comparing the options – 5% withdrawals

6% total return ~ 2.5% Capital Growth / 2% Dividend / 1.5% Interest – 5% withdrawals – 10 year investment – Compound effective tax

AEA of £3,000 used each year. Dividend allowance of £500. Savings allowance £1,000, £500, or £0 (BRT/HRT/ADRT)

If a client is making withdrawals, the offshore bond still works out very well if they will be non-taxpayers on encashment with collectives now also looking attractive for smaller investments. For basic-rate taxpayers, it’s a similar picture – although the client actually pays less tax in a collective if they are making withdrawals. This is also the case for higher and additional-rate taxpayers. So, in my opinion, the 5% withdrawal question is a bit of a red herring – if anything, it makes collectives a little more attractive.

Capital gains and losses

There is one problem with the above analysis. I’ve assumed a total annual return of 6% made up of 2.5% capital growth, 2% dividends and 1.5% interest and I’ve assumed this will be the case year after year. However, this is not how investments work – there are some good years but there will also be some years when returns are not so good. The reality that returns are inconsistent favours a General Investment Account. Why? Because a client can use this to their advantage – in the good years when they are sitting on gains, they can use their capital gains allowance (£3,000 for this tax year).

To use their capital gains allowance, a client obviously needs to sell some assets. However, they cannot buy the same assets back within 30 days because of the disposal matching rules. The exception is if the same assets are bought back within an ISA – this can be done immediately and crystallises the gain. So, when performing a Bed and ISA transaction, consideration should be given to whether the sale should be done proportionally across the different assets or if specific assets should be targeted in order to use up allowances. Also, if ongoing capital gains are a worry, consideration needs to be given to where fees are taken from – again, should the sale be on a proportional basis or should specific funds be targeted? Alternatively, should the fees be paid outside of the wrapper so that ongoing transactions are minimised within the arrangement?

Given that capital gains allowances are now much lower than they once were, it’s more important than ever to consider capital losses as well as gains. In a way, the worst position for a client to be in with a collective is where there is neither a gain or a loss within the year. However, there certainly should be gains and losses within the underlying funds and losses could be targeted here. Why do this? Because losses can be reported to HMRC (this needs to be done within four years) and these can then be used indefinitely to offset capital gains in the future (once the client has used their annual exemption allowances). These losses can offset gains for any assets – not just gains within a collective portfolio but gains from, for example, buy-to-let properties.

Assets held by couples

I said earlier that assets should be held in the most tax-efficient manner. This also especially applies to assets held by couples where their tax rates differ. So, for instance, if a higher or additional-rate taxpayer partly or wholly owns some assets, would it be more tax efficient for the assets to be held by their spouse or civil partner if that person is a basic-rate taxpayer? Assets can be transferred on a ‘no loss, no gain’ basis between spouses and civil partners and so a stock transfer could be a consideration.

Reporting gains and losses

My final point on investing outside pensions and ISAs relates to reporting. If a client has taxable gains, these need to be reported to HMRC and the applicable tax paid in the same way as for taxable dividends and interest. As I’ve already mentioned, losses should be reported too as these can be used to offset future gains. The only other time a client needs to make a report is if they are already registered for Self Assessment and they dispose of assets (not gains) worth more than £50,000. If the client isn’t registered for Self Assessment, they dispose of assets worth more than £50,000 and there’s no tax to pay, then they do not need to make a report.

Capital gains and losses

So, that just leaves me to say that there are lots of helpful reports available to you on the Fidelity platform, including unrealised and tax year specific realised capital gains reports which can be produced on a bulk or individual client basis. These, along with some really useful pension and ISA reports, can be found within the Reporting Services facility within Client Management.