Ethical ISAs and tax efficient investments
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There is a good range of options available for ethical and environmental investors looking for tax efficient savings through ISAs and other investments. This guide explains key considerations, each type of investment available and ethical and environmental options.
When planning an investment portfolio it is vital to consider the impact of tax on overall investment returns. The basic principles of good personal tax planning are:
- Making use of available tax-free allowances for income and for capital gains.
- Making use of your pension contribution allowance.
- Utilising available ISA allowances.
- Considering longer term inheritance tax planning.
- Married couples and civil partners often overlook the advantages of sharing their financial planning. This can lead to valuable higher rate tax relief or other allowances going unused.
- In some cases, usually for investors with larger portfolios, venture capital trusts (VCTs) or enterprise investment schemes (EISs) should be considered
- Off-shore bonds are increasingly seen as another tax efficient investment option, although this area requires careful advice.
Many of our clients are also looking to match their investments with their ethical and environmental values.
What are ISAs?
An ISA is an investment wrapper that can be used to ‘shelter’ investments from personal income and capital gains tax.
ISAs are only available to individuals who are UK resident for tax purposes and over the age of 18 (16 for cash ISAs). In the current tax year you can have up to £11,520 of investment in ISAs, of which a maximum of £5,760 is permitted in a cash ISA. It is not possible to carry over previous year ISA allowances.
There is no limit on the total value of ISA holdings; this has allowed some individuals to accumulate very large sums, all held within tax free savings, in some case over £1 million.
Withdrawals can be made at any time without affecting the tax-free status, although it is not possible to replace capital that has been withdrawn from an ISA.
Ethical and environmental options
There is a very good range of options available for ethical and environmental investors looking for tax efficient savings with most of the market leading investment funds available within ISA accounts.
Additionally, most fund supermarket services offer ISA accounts. This allows individuals to build a properly diversified portfolio of ethical funds within an ISA wrapper.
Offered by banks, building societies and National Savings & Investments, these are deposit accounts that pay interest on the amount invested. They can have a variable or fixed rate of interest.
The advantage is that interest is paid free of income tax. So the higher your personal tax rate, the better the saving.
However, the returns tend to be comparatively low, so the potential tax saved can also be low. You should also consider the rate of inflation – this rate must be taken off of the interest rate you are receiving to give the real return. Over the medium to long term, there is a real risk that the value of your capital could be eroded by inflation.
Cash ISAs do not place your capital at risk, beyond the risk of the establishment becoming insolvent, so can be good for holding funds in the shorter term.
Cash ISAs can be transferred into stocks and shares ISAs at a later date, so could be used to hold half your total ISA allowance. However, it is not possible to transfer a stocks and shares ISA back into a cash ISA.
The most popular ethical cash ISA options are with Triodos Bank and the Co-operative Bank, both of these banks have a strong commitment to corporate social responsibility.
Stocks and shares ISAs
Stocks and shares ISAs offer a lot more freedom and permit investment in shares, unit trusts, investment trusts, open-ended investment companies, life assurance, gilts and corporate bonds. Due to their complexity, you should consult your financial adviser to establish what level of risk is appropriate for you.
The potential returns are much higher on a stocks and shares ISA, so if you hold these types of investment, you are likely to save considerably more tax than on a cash ISA. You also don’t need to worry about losing your ISA allowance if you need to withdraw cash deposits.
Any gains made do not count towards your individual capital gains tax allowance of £10,600. In addition, there are tax savings to be made on income-producing assets. If the income is classed as interest, then it is paid free of tax and if the income is classed as dividend, then the income is paid net of a 10% tax credit (the amount of basic rate income tax on dividends), which unfortunately cannot be reclaimed, but there is no further tax due from those who pay higher or additional rate tax. For this reason, there is less benefit to basic rate tax-payers.
For more tips, see our article on 10 Ways to Use Your ISA Allowance.
Venture Capital Trusts (VCTs)
VCTs were originally launched in 1995 with the aim of encouraging investors to back smaller unquoted companies. VCTs are unregulated collective investment vehicles that are similar in structure to investment trusts and are quoted on the London Stock Exchange.
VCTs provide private investors with an attractive method of investing in small to medium sized AIM/OFEX listed and unquoted trading companies in the UK, in which it would otherwise be difficult to invest directly. Suitable investments are selected by professional venture capital managers appointed by the VCT, under the supervision of an independent board of directors.
There have been a number of successful VCT schemes over the years but then there are also plenty of VCT schemes that have offered very poor real returns to their investors.
Unfortunately part of the problem is the absence of a market for ‘second-hand’ VCT shares. This means it can be difficult for investors to exit after the five year holding period has been completed. For this reason, it is important investors try to understand the VCT managers’ plans for allowing an ‘exit’ from the scheme.
There are a good number of VCTs focusing on environmental investments. For example, Foresight and Ventus invest in renewable energy hardware, focusing on solar and wind energy.
Tax benefits (for the tax year 2013/2014)
VCTs have substantial tax benefits, which can be summarised as follows:
- 30% income tax relief on the amount invested.
- Dividends, including any capital profits paid as special dividends, are paid free of income tax.
- Capital gains made within a VCT are free of corporation tax.
- No capital gains tax liability on gains made on the sale of VCT shares.
In order to retain the full tax advantages of investing in a VCT you must hold the shares for five years.
Types of VCT
There are three types of VCT available:
AIM VCTs invest in companies that are quoted on the Alternative Investment Market (AIM). The benefit of AIM VCTs is that it is easier to see the performance and there is some liquidity in the underlying investments. VCTs investing in AIM shares are likely to be fully invested more quickly, and therefore potentially show higher early returns.
Generalist VCTs spread investments between AIM listed companies and unlisted companies. These VCTs look to profit when the companies are either floated or sold. As they are more concentrated towards unlisted companies than AIM VCTs, generalist VCTs are perceived as riskier.
Specialist VCTs invest mainly in sectors with a more defined investment focus than the generalist VCTs, such as unquoted environmental companies. As such they are perceived to have a higher risk profile than AIM and Generalist VCTs, but likewise do offer potentially greater returns.
Remember income from investments can fluctuate, unit prices can fall as well as rise and past performance is no guarantee for the future. Property funds can be illiquid, as it is not always possible to sell property investments immediately. This could delay future switching or encashment.