Investments That Can Reduce Your Income Tax Bill

Many of your pockets may be smarting from the income tax bill you had to pay on the 31st January. In this article we consider a few options that, if used correctly, can reduce your income tax bill.

Investments That Can Reduce Your Income Tax Bill
Daniel Boden

Daniel Boden

Chartered Financial Planner

Firstly, as with any investment, your capital can be at risk. Below we briefly consider investments that the government incentivises you to invest in through tax breaks. By offering these incentives the government aims to encourage individuals to save for their retirement (thus less reliant on the state in their old age), or channel capital from private investors into certain burgeoning industries or fledgeling businesses to help them get off the ground.

Pensions

Perhaps the most common and effective way of reducing the income tax you pay is by contributing to a pension. A large proportion of the enquiries we receive are following changes made to pensions by the government. We have covered some recent changes in previous articles.  There are many types of pensions; we touch on some of these here. 

How much tax relief do you get? 

Tax relief on contributions is applied at your ‘highest marginal rate’ of income tax. Therefore, basic rate taxpayers will get 20% tax relief, higher rate taxpayers get 40%, and additional rate taxpayers get 45%.
There are limits to the amount of tax relief you can get by making pension contributions. The limit at the moment is the lower of 100% of your earned income or £40,000. The limit may be reduced further if you have already taken an income from your pension, and the rules are also slightly different if a company is making a pension contribution on your behalf. 
Pension tax relief costs the government billions of pounds each year and is regularly in the crosshairs when the government’s purse strings are tightened. Watch this space…

How is tax relief applied?

If you make a pension contribution out of your back pocket, basic rate tax relief is added to your plan by the pension provider. For example, if you contribute £1,000, the pension provider will reclaim £250 on your behalf from HMRC and £1,250 will be invested.

Higher or additional rate taxpayers add the gross contribution to their tax return (£1,250 in this example) and get a tax rebate of £250 for higher rate payers and £312.50 for additional ratepayers. It is important to note that you will not receive higher or additional tax relief automatically; it needs to be claimed from HMRC via self-assessment. 

If you are contributing to a company pension scheme tax relief could be granted in a variety of ways and will depend on how the plan is set up. This may mean still having to apply to HMRC to claim your higher or additional rate tax relief.

Reducing income tax is desirable for everyone but those with income of between £50,000 and £60,000 (and receives child benefit) can potentially avoid a tax charge if income is reduced to £50,000. There are similar concerns for those with income of between £100,000 and £122,000 as between these amounts; you lose your personal allowance (this is the amount of income one can earn without paying any tax, currently £11,000). 

Venture Capital Trusts (VCTs)

VCTs are investment companies that use cash from private investors to invest primarily in smaller companies that operate in certain industries. The government wants to help get the smaller companies off the ground or promote certain industries, such as ‘green energy’, so offer incentives to the private investors to invest into the VCTs. 
VCTs are run by a fund manager who decides which companies to invest in. Given the nature of the underlying companies, VCTs are generally considered only suitable for higher risk investors.

How much is your income tax reduced by?

Unlike pensions, VCT’s offer a tax reduction of 30%, rather than a relief. Investment is limited to £200,000 per annum, giving a maximum reduction of £60,000. For example, for an investment of £10,000 your income tax bill would be reduced by £3,000. The VCT shares have to be held for 5 years, if they are sold sooner, the tax relief is lost.
VCT shares are also exempt from Capital Gains Tax (CGT) and any dividends are distributed tax-free. 

How is the income tax reduction applied?

An investor would inform HMRC, typically by self-assessment, that they have made an investment into a VCT. Using the above example, £3,000 would be deducted from your income tax bill. Importantly, as a tax reduction is awarded against your total income tax liability, relief cannot exceed your total tax liability.

Enterprise Investment Scheme (EIS)

Like VCTs, the EIS scheme attracts private investment to small business by offering tax relief to investors. An individual’s Income tax can be reduced by purchasing shares in a company (or companies) that qualify for EIS funding. Alternatively, individuals can invest in EIS funds, which pools cash from other private investors and spreads this across many companies to try and reduce the risk to investor’s capital. Like a VCT, EIS funds are managed by a professional fund manager who decides which companies to invest in.

Whether an investment is made directly by purchasing shares of a small company or by investing into an EIS fund, EIS investment is generally considered high risk.

How much is income tax reduced by?

A tax reduction of 30% is available on investment, up to £1,000,000 per annum, giving a maximum reduction of £300,000. For example, for an investment of £10,000 your income tax bill would be reduced by £3,000. The EIS shares have to be held for 3 years, if they are sold sooner, the tax relief is lost.
You will not have to pay any Capital Gains Tax on disposal of EIS shares, providing the shares are held for at least 3 years and you must have received income tax relief on the investment.

There are other tax reliefs and advantages to EIS investment which are beyond the scope of this article as we are primarily focusing on the income tax position of certain investments.

How is the income tax reduction applied?

Usually by self-assessment or by a separate claim made to HMRC. 
Tax relief will only be applied once you have an EIS3 certificate relating to your investment, which verifies that the investment qualifies as an EIS investment.  It’s worth noting that it can take up to 18 months for these certificates to be issued, so tax relief may not be immediate.  
As with VCTs, investors need a large enough tax bill to absorb the tax relief. If not, you have to forego the excess tax relief. 

Seed Enterprise Investment Schemes (SEIS)

A more generous counterpart to the EIS scheme, SEIS aims to encourage investment into early-stage companies. SEIS is widely regarded as even higher risk that EIS or VCTs and ideally should be set up with the assistance of a trusted accountant. 

The tax reduction is higher than EIS investments but the investment usually bears a greater risk.

Important notes on VCTs, EIS, SEIS

Above represents a very brief overview of these investments, focusing on the income tax savings that can be achieved. There are other benefits and drawbacks to these investments to consider, which are beyond the scope of this article. 
As with any investment, care should be taken to ensure that the investment is suitable for you. VCTs, EIS, and SEIS investments should be regarded as specialist investments and require extra attention and expertise. With such generous tax incentives offered, it is important not to lose sight of the fact that many of the investments offered are high risk with the potential of significant capital loss and risk of default. Some such investments can also be borrowed or lend money which also adds another element of investment risk to consider. Also, shares in small companies can be ‘illiquid’ meaning they are not always easily traded. This being said, used correctly, these can be a valuable addition to some investor’s portfolios.

Key Points 

  1. Those with income between £100,000 and £122,000 lose their Personal Allowance at a rate of £1 for every £2 of income over £100,000.  Making pension contributions could reduce taxable income below £100,000 which would keep your whole personal allowance intact. 
  2. For those receiving child benefit, reducing income to under £60,000 can prevent you from having to pay a child benefit tax charge.  
  3. Exchanging some of your salary for a pension contribution can reduce your income tax and National Insurance bill.
  4. VCTs, EIS and SEIS provide a reduction in your income tax bill and are considered to be high-risk investments. 
  5. There are other ways to reduce personal taxes. Here we have focused on income tax and investments which can achieve a reduction in your tax bill.

This article is distributed for information purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Ermin Fosse and does not represent a recommendation of any particular security, strategy or investment product. The information contained herein has been obtained from sources believed to be reliable but is not guaranteed. It is not a promotion of Ermin Fosse’s services.

Please contact us before you invest/disinvest. The past is not indicative of future results. When you invest you may not get back what you put in. Errors and omissions excepted.