Edited December 11, 2017
For professional advisers only. Not to be relied upon by retail investors.
It’s easy to argue that the two most important financial needs in a person’s lifetime are to buy a house and to pay for the life they hope to have during their retirement years. This perhaps explains the thinking behind the government introducing the Lifetime Individual Savings Account, or LISA. But both pensions and property have come under increased scrutiny from a tax perspective in recent years, with property investing in the form of buy-to-let coming under particular pressure.
Property investors feeling the pinch
Historically, many people have opted to invest in bricks and mortar as a way to complement or even replace pension planning. But as house prices soar and more people capitalise on the buy-to-let income stream, the government has opted to use taxation to make it less advantageous for new purchasers, and more expensive for many existing landlords. A series of measures have been introduced to reduce growth in the sector, and to potentially free up more housing stock. The measures include a 3% stamp duty surcharge introduced in April 2016 on the purchase of buy-to-let properties and second homes. And in April 2017, we saw the introduction of a phased reduction in tax relief on mortgage interest.
Previously, landlords could deduct 100% of their mortgage interest and other finance-related costs from rental income, thereby reducing their overall tax liability. But now mortgage interest tax relief has been reduced to 75% this tax year, 50% in 2018/19, 25% in 2019/20 and will be zero from 2020/21. To replace mortgage interest relief, landlords will be granted a 20% basic rate tax relief which can be used to offset income tax. Unfortunately, this is likely to push many property owners who were paying income tax at the basic rate into the higher rate tax bracket, despite their effective income from the property staying the same.
But pensions unlikely to benefit
Will the tax implications for property investors see the pendulum swing back in favour of pensions? Not necessarily. Although recent efforts from successive governments to revolutionise the pensions industry are very welcome, one could argue that these efforts have focused mostly on helping to improve extraction of money and transparency around pensions, rather than encouraging people to put more into their pensions, or indeed to start their pension earlier.
In some ways, the incentives to save more have moved in the opposite direction. For a start, pensions now look considerably less attractive from a tax perspective for high earners than they did a few years ago. As recently as 2011, the maximum amount one could contribute to their personal pension over their lifetime (also known as the lifetime allowance or LTA) was £1.8 million, and the annual contribution limit was £255,000.
Since then, the LTA has been on a downward path, having been reduced to just £1 million in 2016. In addition, a tapered annual contribution limit has been introduced, ranging from £40,000 (the upper limit) to as little as £10,000 for those that earn £210,000 or more. The penalty for breaching these new pension limits is severe. If an individual’s pension pot exceeds the LTA, they could face an additional charge of up to 55%.
The implication of this is that many higher and additional rate tax payers will be or have already maxed out on their pension limits and may well be looking for other tax-efficient ways to prepare for retirement. But if property investing is looking less attractive, where next?
Who loves the LISA?
Which brings us to the Government’s latest long-term investment scheme. Launched in April 2017, the LISA is designed to help people save to buy their first home or, alternatively, to build up a nest egg that can be put towards their retirement. But you could argue that in trying to serve two functions, it ends up falling awkwardly between the two.
The LISA’s biggest selling point is that it offers investors a 25% government bonus, on top of a maximum of £4,000 a year of personal savings (e.g. on £4,000 invested the government will add an extra £1,000). But as you would expect, the devil is always in the detail. It is only open to people aged 18 to 40. And once the LISA owner turns 50, they will no longer be able to pay into their LISA or receive the government bonus. If you’re planning to withdraw the LISA amount to buy a property, it has to be a property in the UK, bought with a residential mortgage, and must be valued at no more than £450,000.
And the options for those hoping to use their LISA for retirement come with limitations too. If funds are withdrawn before the holder turns 60, the LISA holder will incur a 25% government charge (unless they have been diagnosed with a terminal illness), leaving people in a worse position than if they had simply saved in a standard ISA. Given these restrictions and complexities, only a handful of providers have come forward offering a LISA and it seems unlikely that LISAs will be high up on the list of adviser recommendations for those seeking to fund retirement.
Venture capital trusts
With both pensions and property investors potentially facing increased taxes, less relief and lower allowances, the significant rise in investor inflows into Venture capital trusts (VCTs) feels entirely predictable. And, from the perspective of a cash-strapped Government, redirecting the marginal cost of tax relief from landlords, and putting it to work in Britain’s brightest young businesses, seems sensible in terms of creating jobs and stimulating economic growth.
Now, investors need to keep in mind that VCTs put capital into high risk, high potential growth businesses. Investors may not get back the full amount they invest. VCT shares could fall or rise in value more than shares listed on the main market of the London Stock Exchange, and may also be harder to sell. It’s also important to remember that tax treatment depends on individual circumstances and may change in the future. Tax reliefs also depend on the VCT maintaining its VCT-qualifying status.
So why are they popular? For investors, a key attraction of VCTs is their ability to pay tax-free dividends (although these aren’t guaranteed), while allowing the investor to benefit from up to 30% upfront income tax relief, provided they are prepared to hold their VCT investment for a minimum of five years. Investors can invest up to £200,000 in a single tax year while still benefitting from the tax reliefs, which are there, in part, to offset the higher risk associated with investing in a VCT. An investor’s tax treatment will depend on their individual circumstances and tax incentives may change in the future. The tax reliefs also depend on the VCT maintaining its VCT-qualifying status.
In recent years, VCTs have become an invaluable, and mainstream, tax-efficient component of retirement plans for high earners. And they’ve experienced another outstanding fundraising year in the 2016/2017 tax tear, with £542 million invested. This is the largest amount for a decade and the second highest fundraising on record, according to the Association of Investment Companies.
With both pensions and property starting to look conspicuously less attractive for many high net worth investors, and with the muted market reaction to the launch of the LISA, it’s a good time for investors to start thinking more holistically about their retirement planning options.More about VCTs
Stuart Lewis was Head of Tax-Efficient Investments
Please read: Personal opinions may change and should not be seen as advice or a recommendation. VCTs are not suitable for everyone. Any recommendation should be based on a holistic review of your client’s financial situation, objectives and needs. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: July 2017 and December 2017. M2-CAM06251