Turning taps – the importance of tax wrapper diversification

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    Turning taps – the importance of tax wrapper diversification

    When we hear the word ‘diversification’ the usual thought process is diversifying our investment portfolio. To remain as tax-efficient as possible, it is important to keep an eye on a fundamental aspect of diversification that investors frequently overlook: tax wrappers.

    “Since the December 2019 election, more than one million over 65s have been dragged into paying income tax, according to Government figures. A total of seven million currently pay income tax.

    Analysis for the Telegraph has revealed that state pension rises and an extended freeze on the personal tax allowance will mean a total of nine million pensioners have to pay income tax, up 29pc from the current total of seven million.

    Two in three pensioners will be required to pay income tax.” (Source: telegraph.co.uk)

    A solid foundation

    So, how do we begin to combat the tax being paid by both earners and retirees using a tax-efficient investment portfolio?

    Let’s run through the core tax wrappers that should be considered within a portfolio:


    When earning, this is typically the first port of call for savings. The tax relief provided at a person’s marginal rate (up to pensionable earnings at a maximum of £40,000 per annum) is a great boost to savings.


    When accessed, 25% of the pension is tax-free and the residual is taxed at a person’s marginal rate. This marginal tax rate, combined with the annual allowance and lifetime allowance limits, means it is important to consider alternative taps and use further tax allowances.


    You might think ‘the ISAs with my bank have been doing poorly for the past 20 years so what is the point?’ The key point here is that the ISA wrapper can be used for an investment portfolio too. Each person can contribute £20,000 to an ISA and the gains are completely tax-free.


    Not only are gains tax-free but withdrawals are too, adding another string to your retirement bow.


    Once pension and ISA allowances are used, we typically look towards the general investment account (GIA), which has no limit on contribution amounts.


    This often disregarded piece of the puzzle is not subject to income tax but capital gains tax (CGT) and as such, provides access to use the CGT allowance of £12,300 per person alongside a CGT rate of 10% for basic rate taxpayers and 20% for higher rate (compared to 18% and 28% for residential property) – please note the CGT allowance is changing from April 2023.

    The misunderstood wrappers

    Now, this is where it gets a bit tricky but the consideration for alternative wrappers can be important to certain individuals when creating a diversified tax strategy.


    Similarly to a general investment account, investment bonds have no upper contribution limit. Investment bonds mainly fall into two categories, onshore and offshore. The main difference is that in high-level terms, those onshore are subject to UK corporation tax, which is offset by your provider, while offshore bond returns roll up the gross of tax in the funds.


    When accessed, both onshore and offshore bonds are tested against a person’s marginal income tax rate. Provided the gain falls within the personal allowance for offshore, and the basic rate band for onshore, no further tax is due.


    Similar to a pension, the specialist EIS and VCTs schemes provide a tax reducer of up to 30% for EIS / VCTs and 50% for SEIS provided they are held for the minimum holding period. An important consideration here is the underlying investments, which are typically smaller companies and consequently higher risk.


    Both income and capital gains are free of tax from these types of specialist investments.

    Example 1 – without tax diversification

    Let’s use an example to show how a couple, who have not considered tax diversification, would generate their retirement income.

    They have worked hard their entire working lives and are excited to retire at age 60 with their significant pension pots of £1,300,000 and £300,000 respectively.

    They would like to generate a retirement income of £70,000 gross with the pension tax-free cash being used to purchase a holiday home. The tax treatment would be as follows:

    Pension income£35,000£35,000
    Less tax-free personal allowance12,570£12,570
    Tax liability (basic rate tax of 20%)£4,486£4,486

    As we can see, this results in a tax liability of £8,972 equivalent to 12.8% of their gross retirement income.

    Another important area to note is that in this scenario, Mr is in breach of his lifetime allowance, which stands at £1,073,100 and as such will pay a minimum 25% tax charge on the excess, equating to £56,725.

    Example 2 – with tax diversification

    Similarly, another couple also aged 60 and now retiring. They engaged with a Financial Planner early in their careers, who explained the importance of tax wrapper diversification.

    Together, they built up retirement savings of £400,000 each into a pension, £200,000 each into ISAs, and £400,000 into a General Investment Account.

    They again would like to generate an income of £70,000 gross per annum with the tax-free cash being used for home renovations. The tax treatment would be as follows:

    Pension income (tax-free personal allowance)£12,570£12,570
    General Investment Account income (CGT allowance)£12,300£12,300
    ISA income (tax-free)£10,130£10,130
    Tax liability£0£0

    As we can see, the planning strategy has resulted in no tax being due on their retirement income. Over the course of their next 27 years assuming average life expectancy, this is an accumulated tax saving of £237,384 plus the fact no LTA has been paid increasing this total to £294,109.


    By having numerous tax wrappers each with different tax treatment, there is the ability to turn on a number of ‘taps’ during retirement ultimately reducing the level of tax paid.

    Alongside this diversified tax strategy, Equilibrium can help you adapt to potential changes in legislation ensuring that your accumulation plan or retirement income stream continues in a positive direction.

    This blog is intended as an information piece and does not constitute a solicitation of investment advice. 

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