Are you taking advantage of these tax-efficient investing methods?

Tax-free wrappers are a big advantage for UK investors, with both ISAs and pensions providing ways for Brits to invest their money without needing to deal with the complications of UK capital gains and dividend tax. These wrappers are well known. But understanding how to use them, where to put your money, and what to do when you’ve used your tax-free allowances can be a bit more nuanced.

Here’s a few methods to consider if you are looking to keep your investments tax efficient, although it’s important to note it’s not an exhaustive list. Investors will also need to think about what exactly they are investing for. It may be that saving more money in their pension is the most efficient way in terms of tax, but if they are looking to purchase a house, they won’t be able to access their hard-earned money at the right time. Sometimes, we can get wrapped up in the process and forget what you’re aiming for in the first place.

Boosting your pension

Pensions are often the easiest way to start investing, because those who are working likely have one already through auto-enrolment. Plus, the tax perks mean you don’t have to pay income tax on your own contributions. However, there are limits to the benefits. You don’t have to pay income tax on contributions up to the lower of £60,000 each year or 100% of your annual earnings, though these contributions start to taper down for those that have both a ‘threshold income’ over £200,000 and an adjusted income over £260,000.

If you have extra funds and have a partner, you can save into their pension too, as long as your contributions along with any others don’t break the £60,000 ceiling or 100% of their income. If they are not currently working, you can contribute £2,880 each year (this comes to £3,600 with tax relief). Using both pensions can also be helpful when it comes time to withdraw your savings in retirement, because both will have the entire tax-free cash allowance of £268,275, whereas saving into a single pot, even if two people are using the money to live on, means just one lump sum allowance.

The bonus that makes saving in a pension even more valuable for many employees is the employer contributions. If you are part of automatic enrolment, your employer will be paying in at least 3% of your earnings to your pension in an extra contribution, on top of your 5%. But many employers will go further in matching this and contribute the same amount as you or more. In some cases, that could mean that you are doubling your pension savings.

Once your money is in the pension wrapper, your investments are sheltered from UK income and capital gains tax.

Are you better off saving in an ISA?

Pensions tend to be one of the most efficient ways to save, since you are often getting tax relief on the money along with employer bonuses. But because they can’t be used until age 55, rising to age 57 by April 2028, they’re not very helpful for shorter-term goals such as buying a house or paying for school fees.

Up to £20,000 can be put into ISAs each year, but the money is sheltered from any tax on capital gains, dividends, or interest. Each adult has their own £20,000 allowance, meaning that between a couple, you can invest £40,000 free from tax. If your married or in a civil partnership, you can gift that money to your spouse without any tax implications, but once you’ve gifted it, keep in mind that it’s legally theirs. Children also have a £9,000 allowance that can be put into a Junior ISA. This money cannot be touched by anyone until the child turns 18, when it’s turned into a regular ISA and they can do what they please with it. But, according to our research, most children choose to keep saving after that point.

This means that for a family of four, you could potentially invest £58,000 each year tax free through ISAs. And coupled with your pension allowances, that could become £178,000 each year tax free. If you’re really looking to give your children a leg up, you can put money in a Junior SIPP, beginning their pension savings. You can put £2,880 in each year, bringing total tax-free contributions for a family of four to £185,200, post tax relief.

Most of us do not have £185,200 to put aside, so we will need to pick and choose. If you have immediate life goals to pay for, like purchasing a home, you’ll likely want to lean more heavily into an ISA so you can get there in a reasonable amount of time. Set your goal for your deposit, and map out how long it will take you to get there. For most people, it will make sense to save into their pension still to some degree, to keep them involved in automatic enrolment and take advantage of employer bonuses.

Have more to save? What you can do

Tax efficiency becomes a bit more complicated once you’ve used up any pension and ISA allowances, but there are still areas to consider. You will still have £3,000 in capital gains that can be realised each year, and you must offset any losses in the same year before using that allowance. So, for example, if your stock in Alphabet has grown by £5,000 since you’ve owned it, but you’ve lost £2,500 in another stock this year, your net gain is just £2,500. If those were the only investments you sold that year, it means you wouldn’t owe anything in capital gains tax.

Choosing tax efficient assets

There are a few assets that remain tax efficient, even if they don’t sit inside a tax wrapper. A popular option is gilts, which still face income tax but no capital gains tax. Coins issued by the Royal Mint are also free of capital gains tax, but note that gold bars are not. These can also be difficult for people to store and sell, as you are purchasing the physical coin.

There are also government schemes designed to help unquoted companies raise finance by giving investors tax relief on their investments. These are only for those that are comfortable taking a large amount of investment risk, due to the nature of what they invest in. Venture Capital Trusts (VCTs) are one example.

VCTs are a high-risk investment vehicle that invests in early-stage companies. The VCT itself is listed on the London Stock Exchange and will invest in a number of shares across different companies. While many of these companies will likely fail, the idea is that there could be a few big winners that offset the losses. To support the schemes, the UK government offers tax incentive to VCT investors. You can invest up to £200,000 in VCTs in a tax year, and in turn receive 20% in income tax relief if you hold the assets for five years. You will also not face any capital gains tax on the investment if it's held for five years and will face no dividend tax. So, if you invested £100,000 into a VCT, you could get an income tax credit of £20,000 for that year, although the credit you receive cannot exceed the income tax you owe. This might sound like a very good deal but remember these are high risk investments. There is a chance you could lose all the money you invest. There are some VCTs you can access on the AJ Bell platform.

Investing in property

Some people also invest in property with their extra cash, but if it is not your primary home, you can quickly run into other tax and regulation challenges. Second homes not only pay an extra 5% on top of typical stamp duty land tax when they are purchased, but you’ll face income tax on the rental income and potentially capital gains tax when you come to sell. Be aware that local councils can also enforce a second home surcharge on your property, which is up to 200%. This is at the discretion of each council, so it may be worth researching before you buy. If you plan to let out the property when you’re not there, it’s worth noting the restrictions around it, and checking for any local ones as well.

While a second home is likely not a very efficient tax move, it doesn’t mean that it can’t still be on your bucket list. Remember that you’re building wealth to enjoy it, so if a summer home in Cornwall is what speaks to you and you can afford it, just because it isn’t tax efficient doesn’t mean it’s not the right move for you.