2024 Guide to Tax-Efficient Investing in the UK

With taxes on the rise, leveraging the power of tax-efficient and tax-free investing strategies is crucial in 2024. Shares and investment funds can be taxed in various ways. For traders, stamp duty tax is paid for every transaction. Investors also pay income taxes on dividends received and capital gains tax (CGT) on any profits when they sell shares.

Inheritance tax is also collected when a person transfers their holdings to a family member or friend. All these taxes add up over an investor’s lifetime, sometimes costing individuals millions of pounds!

The good news is that the government wants us to invest in listed businesses. There are many reasons for this. Firstly, holding wealth in bank accounts keeps money out of rotation. But reinvesting money, earning a passive income, and maximising life savings, all have strong upsides to the economy.

It benefits businesses, reduces the burden of senior care on the government, and encourages foreign investments. This is why the UK government offers various tax incentives and schemes that anyone can use to reduce their tax liability.

What are tax-efficient investments?

In general, tax-effective investments allow the holder to receive some kind of tax relief on profits made on their invested capital. They help reduce a person’s tax liability through claims, create a tax-free saving, or just help offset some taxes paid. 

In this article, we will look at the investment instruments that incentivise investors through tax benefits. Sensible tax planning can create a lot of free wealth over an investor’s lifetime.

Although there are no guaranteed returns in the market, some of the top private investors in the UK rely on tax benefits to maximise capital gains. These benefits are available to the larger public as well.

Let us delve deeper into the world of tax-effective investing in the UK. 

Why is tax-efficient investing important?

Traders know the value of tax-effective investments. The average day trader makes multiple transactions every month. As a result, they tend to have a good grasp of taxes paid to the exchange and deducted from capital gains. But for investors who hold shares for decades, the unrealised profits on portfolios often do not match up to the final payout. And they do not realise this until it is too late. 

A crucial pillar of effective financial planning is maximising personal savings. It is important for every long-term investor to explore these tax-free investment instruments.

Tax-efficient accounts

Let’s start with two of the most popular tax-efficient ways you can shelter shares and investment funds.

Individual Savings Account (ISA)

If you keep shares in an individual savings account (ISA), then they should be protected from any income tax on dividends and capital gains tax on any profits you make. The annual ISA allowance, meaning the amount of cash you can put in, is £20,000 for the current tax year of 2022/23.

There are four primary types of ISA:

• Cash ISA
• Stocks and Shares ISA
• Innovative Finance ISA
• Lifetime ISA

Each of these ISAs has a different focus and purpose. A Cash ISA is a savings account where a person never has to pay tax on the interest earned. This is popular with students and parents who want to save for a college fund.

A Stocks and Shares ISA is a bank account through which a person can buy and sell stocks free of taxation. An investor can pick from a range of stocks and funds depending on the Stocks and Share ISA they choose and invest in them as they see fit. 

Innovative Finance ISAs are slightly different to standard Cash and Stock ISAs. They allow investors to lend or borrow capital directly from each other. This peer-to-peer system cuts out the intermediary, which means higher interest earned and more flexible repayment periods. But there are also significant risks to consider when lending or borrowing using Innovative Finance ISAs. Since these are not as regulated as bank loans, they have a much higher risk profile. There have been multiple cases of borrowers losing access to the money or issues with platforms running Innovative Finance ISAs. 

Lifetime ISAs are accounts that people can deposit money into for long periods and accumulate untaxed annual interest. They can be used by anyone over 18, but the first deposit should be made before age 40. There is an annual deposit limit of £4,000. The government will add a 25% bonus, up to a maximum of £1,000 per year. These ISAs can hold cash, stocks, or bonds and are very popular with younger families. 

Self-Invested Personal Pension (SIPP)

Pensions are a great way to save for retirement while getting a few tax cuts along the way. In the UK, private pension contributions are tax-free up to certain limits. These exemptions are available across most different pension schemes like workplace pensions, private pensions, and overseas pensions. 

For Self-Invested Personal Pensions, up to 25% of the total value is considered a tax-free lump sum. For example, if a person has £50,000 invested in a pension, 25% or £12,500 can be withdrawn tax-free. But the remaining sum is taxed as per pre-determined levels by the pension provider. 

Pensions are diverse and these percentages depend on a range of factors like the lump sum amount invested by the individual, age at the withdrawal, and value of other pensions held. For example, you will have to pay tax if the pension value exceeds 100% of your earnings in a year or if its lifetime value exceeds £1,073,100.

Specialist investment types

It’s also worth highlighting a couple of specialist investment types that offer additional tax relief.

Venture capital trusts

A venture capital trust (VCT) is one of the oldest investment schemes. They involve pooling the monetary resources of a group of investors to purchase shares in publicly listed companies. VCTs are exempt from corporation tax on any capital gains when an investment is sold. They are usually shares that trade on the London Stock Exchange that receive various tax exemptions. 

Generally, these only apply if you subscribe for new shares and hold them for five years, rather than buying them in the open market via a broker. Dividends gained during the holding period are also exempt from tax for investors over the age of 18. 

But the main attraction is the 30% income tax relief on up to £200,000 each tax year. This is what makes VCTs so popular among long-term traders with a structured investment approach. However, VCTs do not guarantee returns. 

Outside of the tax exemptions, the final returns from the VCT are determined by positive price growth over time. And some VCTs have performed poorly in the past. In some cases, they have wiped out any tax relief received in the first place. It is important for investors to look at a company’s business fundamentals and pick stocks with decent long-term potential. 

Enterprise investment schemes

As the name suggests, an enterprise investment scheme (EIS) is designed primarily to help businesses raise capital. An EIS encourages private and public investors to purchase shares of a business and receive tax benefits in return. An investor is eligible for a 30% income tax relief on any new shares they purchase. There is a maximum tax exemption of £1m.

With an EIS, a business can raise up to £5m each year. Over the lifetime of its operation, the limit is £12m. This also includes amounts received from other venture capital schemes. Due to the nature of an EIS, qualifying companies are typically privately owned companies with gross assets of less than £15m. EIS aims at helping small and medium-sized businesses grow.

A sub-category of EIS is the seed enterprise investment scheme (SEIS). A SEIS is designed to support a company before its first listing on the stock market. It does this by offering tax relief to individuals who are willing to be seed investors in a company. 

Typically, the investors in a firm’s EIS and SEIS have to hold these shares for a period of three years. After, they can choose to sell their shares and pay no capital gains tax on profits. Depending on the initial investment, profits from EIS can be significant. This makes these tax cuts desirable to venture capitalists and angel investors. 

What are the tax-free allowances in the UK?

Let’s say someone is investing with a regular brokerage account or putting money aside in a standard savings account. In this scenario, an annual tax-free allowance on interest, dividends, and capital gains is earned.

These thresholds are constantly changing with the fiscal policy set by the UK government. However, the table below outlines how much investors can earn before taxes enter the picture.

Over the last few years, the annual tax-free allowance for interest on savings hasn’t changed. However, for capital gains and dividends from investments, the threshold has been significantly reduced. Therefore, unless investors start using tax-efficient accounts like a Stocks and Shares ISA or a SIPP, their tax bill will be significantly higher.

What is the most tax-efficient investment in the UK?

We’ve already explored some of the best tax-efficient investment vehicles in the UK. And while it depends on individual circumstances, the best option is arguably a Stocks and Shares ISA.

This account comes with certain limitations. As of the 2024/2025 tax year, only £20,000 can be deposited each tax year across all ISA accounts. However, most British investors never reach this maximum threshold, making it a largely negligible roadblock. In the meantime, all investments held in this account are immune from capital gains and dividend taxes, enabling investors to build their wealth without HMRC slowing the progress down.

Tax-efficient investing strategies

Tax-efficient investing is a case-by-case issue that requires analysis of an investor’s needs, time, and capital available. The different methods discussed above have very particular use cases that can help maximise and individual’s savings. This guide aims to serve as a starting point.

One or a combination of these methods can be used to maximise returns from a portfolio and save for the future. But a tax-effective investment strategy involves careful planning and consideration of needs. There are many limits in place to avoid exploitation. These can be confusing to a new investor. This is why careful research is crucial before making big financial planning decisions. 

Also, picking the right fund manager is very important. Many private investment firms operate ISAs, VCTs, and tax-effective investment tools. Higher levels of transparency behind changes in allotments, sector-wise splits, and how funds will be utilised should be monitored. Looking at different basket investments and studying them carefully is the first step to finding the right fund manager. 

While this guide outlines the possible ways a person can take advantage of these tax benefits, there are several finer details to consider. As always, The Motley Fool believes in investors researching every investment thoroughly. All these tax-effective strategies do carry risks. Before investing, it is prudent to gather all the available information and understand the best route for every individual portfolio. 

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.