Surely not another budget blog?
Part one focussed on the facts (click here); today’s on the potential planning opportunities it creates – which products/strategies move up the agenda, and which move down.
I focus on three areas – capital gains tax; inheritance tax; and pensions.
Capital gains tax
To recap, capital gains tax ‘CGT’ rates have been increased (overnight) to 18% for basic rate taxpayers and 24% for higher rate, thereby aligning them with the equivalent rates for residential properties.
On the one hand, this was less of an increase than feared – some had suggested CGT rates could be aligned with income tax, so 20% (basic rate), 40% (higher) and 45% (additional).
On the other, in the space of just a few years, the tax-free allowance on realised capital gains (the so-called ‘Annual Exempt Amount’) has been reduced from £12,300 per person per tax year to £3,000 and now rates are on the up too.
From an investing perspective, the relative ‘loser’ from these changes is the General Investment Account ‘GIA’, where investment income and realised capital gains are liable to tax.
We think GIA’s are still effective for basic-rate taxpayers - 8.75% tax on dividend income above £500, and 18% tax on realised gains above £3,000 still equates to a relatively attractive ‘effective tax rate’ on combined investment profits, likely somewhere in the mid-teens. But less so for higher-rate taxpayers.
Planning opportunities
The latest changes make it more important than ever to make full use of available allowances – ISAs, pensions and inter-spouse transfers. It also pushes investment bonds and, in certain circumstances, Venture Capital Trusts ‘VCTs’, up the agenda (see below).
Investment bonds
Investment bonds offer the ability to defer tax on investment profits to the point of policy surrender – the play here is to invest during a period as a higher/additional rate taxpayer; and cash in as a basic rate or even non-taxpayer. You can also take tax-deferred withdrawals (i.e. no immediate tax) of up to 5% of the initial investment amount per year (which accumulates if not used); and can assign sub-policies (aka. segments) to others, which moves the point of taxation on to them.
Here’s a previous blog I wrote on the mechanics of these.
VCTs
VCTs are special types of companies listed on the stock exchange. When you invest in a VCT, you buy new shares in a single VCT company. That VCT company invests in a large number of other companies on your behalf, effectively diversifying across a wide number of underlying businesses. However, there are strict criteria as to what that company can invest in, in terms of company size, number of employees and age. These criteria mean that in reality when you invest in a VCT, you’re investing in small, mostly unlisted, high-growth, entrepreneurial businesses.
Given the added risks of investing in such early-stage businesses, VCTs are classed as very high risk and are not suitable for everyone. However, in certain instances, they can be a good diversifier and come with generous tax breaks to encourage investment in such enterprises:
- 30% income tax relief on the initial investment,
- Tax-free dividends (the main source of return on underlying company ‘exits’), and
- Tax-free capital gains.
You can read more about VCTs in this previous blog from February.
In yesterday's Budget, Rachel Reeves extended the scheme for another 10 years.
Disclaimer: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). The Financial Conduct Authority does not regulate tax advice. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.
Venture Capital Trusts ‘VCTs’, Enterprise Investment Schemes ‘EISs’ and Business Relief investments are high risk products and not suitable for the majority of retail investors.
Inheritance tax
At present, roughly 6% of households are caught in the net of inheritance tax. With the announced changes around Business Relief ‘BR’, Agricultural Relief ‘AR’ and pensions (next section), this is set to widen considerably.
Starting with BR and AR, the Chancellor announced some major changes:
- From April 2026, the first £1 million of combined business and agricultural assets will continue to attract no inheritance tax, but for assets over £1 million, inheritance tax will apply with 50% relief, at an effective rate of 20%,
- A 50% relief now applies in all circumstances on inheritance tax for shares on the Alternative Investment Market ‘AIM’, and other similar markets, setting the effective rate of tax at 20%.
Yesterday, the AIM market staged a ‘relief rally’ (up +4%) having previously sold off sharply on concerns that the IHT exemption could be scrapped entirely.
However, the question now is whether the 20% ‘head start’ (vs previous 40%) is enough of a carrot to justify running the gauntlet of the AIM market, which is extremely volatile.
Take the last five years for example. Whilst this has been something of a ‘perfect storm’ for smaller UK businesses in terms of COVID; a rise in financing costs; and a cost-of-living crisis, the AIM Index has lost approx. -17% over this period. And now we can add a higher tax burden to the list of obstacles for these smaller businesses. In contrast, the MSCI World Index (a proxy for global stocks) is up +64% over the same period.
Planning opportunities
In terms of planning opportunities, the clampdown on BR likely moves the dial in favour of other inheritance tax planning options, namely:
- Direct gifts (perhaps with accompanying term insurance for those concerned about the 7-year rule),
- Transfer of assets into a trust,
- Whole of life cover (still an under-appreciated tool in inheritance tax planning – here’s a previous blog).
Or simply go out and spend it!!
There is also another form of BR investment outside of AIM, referred to as ‘traditional’ or ‘unquoted’ BR schemes.
These represent investment in large, well-established but privately-listed investment companies that engage in BR-qualifying activities, typically funding renewable energy projects and/or asset-backed lending to quasi-government organisations.
Our understanding is that these will continue to attract 100% IHT relief up to a value of £1m as per the wider BR rules.
Disclaimer: The Financial Conduct Authority does not regulate Inheritance Tax Planning. Inheritance Tax thresholds depend on your individual circumstances and may change in the future.
Pensions
Finally, pensions.
There were lots of rumours into this budget, most notably (and worryingly):
- A reduction in pension tax-free cash limits (from the current £268,275),
- A harmonisation of tax relief on pension contributions across all tax bands, and
- Employer national insurance applying to employer pension contributions.
Thankfully, we didn’t get any of the above. However, the major change we did see was that from April 2027, pensions will be included in one’s estate for inheritance tax purposes.
To highlight the potential impact of this, and how it would apply in practice, consider the following example:
During her working life, Ana made contributions to a defined contribution pension scheme. At the date of her death, aged 80, the pension fund is valued at £400,000. The remainder of her estate is valued at £1,000,000. Following her death, Ana’s pension fund will be paid to her children, as per her expression of wishes.
Note, Ana is widowed and inherited 100% of her late husband’s nil-rate bands and her estate includes a main residence valued in excess of £350,000.
Current position
Under current rules, Ana’s estate is valued at £1,000,000 and is free from inheritance tax, falling just within her available nil-rate bands (2x £325,000 standard plus 2x £175,000 residence nil-rate bands).
The DC pension does not form part of her estate and therefore passes to the children completely free of IHT.
Position from 6 April 2027
Under the proposed new rules, Ana’s pension is included in her estate, increasing the value to £1,400,000.
As such, the estate is now liable to IHT of £160,000 (40% on the £400,000 excess above her nil-rate bands).
My understanding is that there will be a pro-rata deduction between the pension and non-pension assets – the pension scheme will be liable to pay IHT of £45,714, and the Personal Representatives of Ana’s estate the remaining £114,286.
The net result is that Ana’s children would now inherit a pension worth £354,286 (£400,000 - £45,714 IHT).
Double death tax
But the ‘sting in the tail’ here is that because Ana died after age 75, her children will also be liable to income tax on any subsequent withdrawals, leading to an effective ‘double death tax’.
Say they’re higher rate taxpayers and want to access the funds immediately, this could ‘whittle’ the remaining pension savings down to £212,572 (£354,286 less 40% income tax).
Incorporating the additional £114,286 IHT charge levied against her other assets, this is equivalent to an effective tax rate of 75% (!!).
Planning opportunities
Pensions currently play a key role in inheritance tax planning. The general ‘rule of thumb’ for those facing a sizeable IHT liability has been to leave pension savings untouched for as long as possible, whilst drawing on other assets that do form part of the estate to meet ongoing spending needs in retirement.
That now warrants a rethink (assuming the new rules are passed after a consultation phase).
Rather than optimising for inheritance tax, the better strategy may now be to optimise for income tax throughout the course of retirement. For example, limiting taxable pension income to no more than the basic-rate tax band and then topping this up from other non-pension investments, say ISAs and investment accounts.
It also warrants a rethink on pension beneficiaries. For those facing a ‘double death tax’ of IHT and then income tax (i.e. those aged 75 or above), it might be best for the pension to be inherited by minor children, with their full tax-free allowances available, rather than higher rate tax paying adult children.
Disclaimer: A pension is a long-term investment, and funds are not normally accessible until 55 (rising to 57 from April 2028). The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.
Keep calm & carry on
Three closing points:
- The above represent modest tweaks in strategy, not major overhauls,
- It’s important not to let the ‘tax tail wag the investment dog’. We work to limit the tax drag on investment returns, but it’s as important to make sure those investments are working hard in the first place,
- Most important, the rules could change again. We may well have a new government in around 4 ½ years’ time and that could bring in another raft of changes. Trying to anticipate these is a fool’s errand – we take taxes as they come and plan accordingly, making minor tweaks here and there but avoiding knee jerk reactions.
If you’d like to discuss what the budget means for your finances, I invite you to book a Teams call via the following link: Book Teams call.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require in order to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
