Unit Trusts & ISAs
Individual Savings Account (ISA's)
ISA's are very tax efficient savings vehicles as they allow you to invest in either cash and/or stocks and shares without paying any income or capital gains tax on them. Plan managers are however unable to reclaim 10% tax credit on dividend income.ISA funds are included in your estate for the calculation of inheritance tax. Since April 2008, all PEPs have automatically become Stocks & Shares ISAs and are subject to ISA rules and regulations.
Because ISA's are so tax efficient the amounts that can be paid into them is restricted in each tax year. The rules have just altered and it is now possible to pay up to £10,200 from this tax year, 2009/10, if you are over the age of 50 (from April 10/11 otherwise). This can either be split 50:50 between a cash ISA and an equity ISA or alternatively contribute the full amount of £10,200 into a stocks and shares ISA (equity ISA).
Aside from the investment tax advantages that ISA's offer, they also allow you to take a tax-free income from the plan without impacting on your income tax status and any age allowances.
There are hundreds of different ISA providers to choose from, but at Isis Financial Planners we favour using a "supermarket provider" (this name does not refer to a "High Street" supermarket!). This type of provider allows investors to select funds from a wide range of fund management groups which isn't possible with a single plan manager. This means that we can select the best performing and most suitable funds for you from various fund management groups.
Portfolio of Unit Trusts
A unit trust account is very similar to an investment ISA but it doesn't have the same taxation advantages in that any gains are theoretically subject to capital gains taxation. Any dividend income comes with a 10% dividend tax credit and this is treated as tax paid for basic rate taxpayers. Higher rate taxpayers would be subject to an additional 22.5% on the dividend income. On death, the plan proceeds would form part of your estate for inheritance tax purposes but this is no different to an ISA.
In respect of the potential for capital gains taxation, it will be important to utilise the individual annual capital gains tax allowance of £10,200 (for the tax year 2009/10). This allowance is usually increased each year in line with inflation. By using this allowance for switches and transfers to your ISA account, it should be possible to avoid capital gains taxation although this can't always be guaranteed of course.
Capital gains tax would become payable if a gain of over and above the personal allowance is generated. The tax rate has recently been lowered to 18% regardless of an investor's tax position, making this an attractive proposition for a higher rate tax payer of 40% and even more for a tax payer liable to the new high rate of 50% for income above £150,000 from next year.
As for an ISA provider, we would favour using a supermarket of funds allowing access to a variety of suitable funds and investment fund management philosophies. It would make sense to use the same overall umbrella provider for a portfolio of Unit trusts and ISA for simplicity of administration.
Onshore investment bonds
Onshore bonds have a special way of being treated for taxation purposes. Essentially the underlying fund is taxed at a special rate applicable to life offices. This means that returns from these bonds are treated as having suffered savings rate tax of 20% already. A basic rate taxpayer has no further tax to pay while, for a higher rate taxpayer, there is, in effect, a 20% tax credit. Investment bonds are technically insurance plans. They do contain a very small element of life insurance and hence it is necessary for there to be a life, or lives insured, although there is no underwriting involved. I envisage that you would both be the lives assured. There are many life insurance companies that offer this type of plan and nearly all offer the types of funds that are required.
In addition, it is possible to take up to 5% p.a. of the amount invested as a withdrawal in each policy year for up to 20 years and this is treated as a return of capital over this period. No income tax is therefore payable on withdrawals of 5% or less at the time they are taken - the tax liability is deferred until the bond is fully encashed. The 5% limit is also cumulative, so if no withdrawals were made for a number of years but income were required at a later stage, more than 5% could be withdrawn without incurring a tax liability.
If withdrawals are made which are in excess of the 5% limit, a calculation is made to work out the gain and higher rate taxpayers will pay income tax (not capital gains tax) on the gain at 20% - the difference between the savings rate and the higher rate. A similar calculation is made when the bond is fully encashed. The gain is ‘top-sliced', which means that it is spread over the number of years the bond has been owned. This means that the additional tax liability would be reduced (and possibly removed altogether) if you were a basic rate taxpayer in retirement.
Offshore investment bonds
Offshore bonds are another kind of investment bonds that are normally based in jurisdictions where there is little or no local taxation of non-resident investors' funds. This means that the funds should grow at a faster rate - this feature is often referred to as ‘gross roll-up'.
As there is no corresponding ‘tax credit' for offshore bonds, a higher rate taxpayer will pay 40% on all gains over the 5% cumulative limit, while a basic rate taxpayer will pay 20% on gains above that limit. Withdrawals of less than 5% p.a. are, as with onshore bonds, not subject to tax when taken, and no entries fall to be made on the tax return.
In some offshore jurisdictions, investor protection can be an issue. We would only recommend bonds based in countries such as the Isle of Man, the Channel Islands and Ireland, where investor protection is as good as that provided in the UK.
Offshore bonds also have access to a wider range of funds than onshore bonds.
Often, offshore bonds carry higher charges. There are a number of commercial reasons for this, including higher marketing costs and the fact that the life companies cannot claim tax relief for their expenses. There are specific reasons why we would recommend an offshore bond to a client dependent on individual circumstances such as your domicile or future residency status.
Fund rating and monitoring
This fund selection should be consistent with your attitude to risk and the asset allocation agreed. We use a number of research tools offered by well-known, reputable organisations such as Standard and Poors, Morningstar or Micropal.
Micropal, for instance, uses a star-ranking system over the last 3 years to help advisers and investors evaluate the performance of a fund and the consistency of that performance relative to other funds in its sector. The rankings are a measure of the relationship between the level of risk and the monthly performance of a fund over 36 months. For example, a fund may be top quartile over one, two or three years, but in between any of those times it could have lost and regained maybe 40% of its value. It is likely to be assigned a lower star ranking.
In a sector containing 100 funds, the top 10 funds will be assigned five stars; the next 20 funds will be assigned four stars; the next 20 will receive three stars; the next 25, two stars; and the bottom 25, one star.
This star rating will be a guide to the performance of individual funds, with further input such as the reputation and consistency of the investment team behind the fund manager.
Diversification between sectors, fund managers and asset classes will ensure that your portfolio performs as much as possible within the market and fulfil your financial objectives. But always remember that equity investment can always go up or down.
If you are interested in more information about Unit Trusts or ISAs contact Isis Financial Planners.
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