While investment returns dictate future wealth, tax-efficient investing is equally crucial. This includes a range of investment vehicles and strategies that can greatly impact your long-term wealth. It's also important to remember that wealth protection is as important as wealth appreciation, which many overlook as they continually look to maximise their returns. Before we go any further, let's consider the impact of taxes/charges.
If you started with $100,000 and achieved a 5% annual increase, then after ten years, your investments would be worth $162,889. If we now assume that taxes reduced the yearly increase to just 4%, after ten years, your investments will be worth $148,024, a difference of nearly $15,000. Over 40 years—the typical lifespan of a pension—the impact of even small deductions compounds significantly on long-term returns.
We will now examine smart strategies for tax-efficient investing and how they should be incorporated into your long-term investment strategy.
Tax-efficient investments by region
While the range of tax-efficient investment vehicles differs from country to country, this list will give you an idea of the opportunities:
Far East
Mandatory Provident Fund (MPF) in Hong Kong
Contributions to an MPF are tax-deductible to a certain level, with investment returns growing tax-free within the fund. Withdrawals are only permitted upon retirement.
Supplementary Retirement Scheme (SRS) in Singapore
An additional type of pension savings plan, SRSs offer tax-deductible contributions and a significant range of investment opportunities. Gains within the fund are tax-deferred.
Nippon Individual Savings Accounts (NISAs) in Japan
NISAs allow Japanese residents to invest tax-free up to an annual limit, with gains and income exempt for a limited period.
Real Estate Investment Trusts (REITs)
REITs are popular in Far East markets, specifically Japan and Singapore. They offer tax-efficient income through dividends that often receive favourable tax treatment or specific treaty-based exemptions.
United Kingdom
Individual Savings Accounts (ISAs)
UK residents can contribute up to £20,000 per year to an ISA, with income and capital gains within the fund free of tax. There are various types of ISAs, such as Cash, Stocks and Shares, and Lifetime, and you can also contribute to a Child’s ISA.
Pension Plans
Numerous types of pension plans work under the same system: tax relief on contributions with income and capital gains free of tax. Withdrawals (generally with an element of taxation) aren’t allowed until the specified retirement age in the plan terms and conditions.
Enterprise Investment Scheme (EIS)
An EIS provides income tax relief and allows for capital gains deferral, making it ideal for those with substantial gains. It is particularly popular with high-rate taxpayers.
Venture Capital Trusts (VCTs)
The VCT sector in the UK has been very successful, attracting growing investment into smaller, high-risk investments with growth potential. Like the EIS system, there are tax benefits in the form of income tax relief.
United States
401(k) plans and Individual Retirement Accounts (IRAs)
These are two types of popular pension plans. 401s provide tax benefits on contributions and capital growth until withdrawals in retirement. Traditional IRAs offer similar benefits, while Roth IRAs differ slightly. Roth IRAs provide no tax benefits on contributions, but withdrawals are not subject to tax.
Health Savings Accounts (HSAs)
Healthcare is a hot topic in the US and worldwide, and many governments are now encouraging individuals to take out private healthcare plans. An HSA offers tax-deductible contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses.
Municipal Bonds
Municipal bonds are useful for raising funds for state authorities, cities, and other government bodies. They can be exempt from federal and state taxes depending on where they are issued.
529 College Savings Plans
The 529 college savings plan offers a means of contributing to your children’s future education costs, with tax benefits for contributions, capital gains and withdrawals for qualified educational expenses.
Encouraging investment
While numerous crossover points exist regarding some of the above tax-efficient vehicles and strategies, others are unique to countries and regions.
On the face of it, providing tax benefits for contributions, gains, and withdrawals is a significant giveaway by governments. However, there are long-term benefits to national finances with future direct costs concerning education, pensions and other areas of finance reduced.
Tax loss harvesting
While the laws covering tax losses can vary from country to country and even state to state, the concept is the same: offsetting tax losses against taxable gains can reduce your tax liabilities.
In the UK, tax losses can be carried forward indefinitely, provided they are correctly reported to HMRC. This is especially important after the government recently reduced the individual capital gains tax allowance from £12,570 each tax year down to £6000 and then to £3000 for the current tax year. It’s also essential to note that, as in the UK example, you utilise your annual allowance before using any backdated capital losses. This allowance, and any brought forward losses, can only be used to offset capital gains, not income.
Historically, many people would sell a loss-making investment on the last day of the tax year and buy it back the next day to crystallise the loss but retain the investment. Known as a "bed-and-breakfast," this tax loophole has been closed, although, in theory, you could sell an investment in your name and buy back the same shares in a different investment vehicle, such as an ISA.
As national budgets worldwide come under pressure, governments are looking to replenish their coffers by reducing reliefs and increasing tax revenue. This demonstrates why planning ahead is critical.
Capital gains management
Capital gains management should be central to any tax-efficient strategy, though details vary by country. A short-term capital gain is typically one from an asset held for less than 12 months, with long-term capital gains taking in assets held for more than 12 months.
Tax charge
Significant international differences exist, with the US taxing short-term gains as income and long-term gains as capital gains. Conversely, in the UK, there is no timeline differential for basic capital gains (unless trading is your primary business).
Deferring gains
In the UK, many investors manage their capital gains by selling sufficient investments to utilise their capital gains tax allowance without creating a tax liability. They are then free to sell more investments, creating more capital gains in the next tax year, using their refreshed annual capital gains tax allowance.
Tax deferral
As we mentioned above, VCTs, EIS, etc., are means of deferring tax until later. Also, the longer you hold one of these investment vehicles, the more opportunities you have to use your annual allowance or take advantage of enhanced tax benefits.
Inheritance tax
While capital gains tax differs greatly from inheritance tax, they can significantly impact your finances. Consequently, tax-efficient investing over a prolonged period can shield an element of your estate from inheritance tax. It's essential to investigate the regulations in different countries and how your country treats the global assets of residents.
There is a lot to consider when it comes to managing your capital gains, although there are several tax-efficient investing strategies that you can adopt. This also highlights the benefit of a pre-end-of-tax-year meeting with your adviser to review your investments, income, finances, and potential tax liabilities. Tax relief and allowances are usually available on a use-it-or-lose basis; don't forget!
Dividend income
While dividend income is typically added to annual income and taxed accordingly, some variations exist. For example, some investment dividends will qualify for tax relief while others, such as those relating to investments in a pension or ISA, are tax-free. Some companies also offer Dividend Reinvestment Plans (DRIPs), which may present cost and deferred tax benefits.
On another note, holding investments within a tax-efficient investment vehicle may offer even more significant financial gain when investing in companies providing a relatively high dividend yield. While this will be beneficial for income tax savings, it would need to be compared and contrasted against potential capital gains tax benefits for growth investments.
Conclusion: Maximising tax efficiency in your investment portfolio
Tax-efficient investing is difficult enough without constantly changing regulations. There are also significant variations across different countries, although general themes include tax benefits and tax relief for pension savings. The key to successful tax-efficient investing is minimising taxes while strategically positioning your assets for long-term growth. Not easy!
Contact Scott Kingsley today if you would like to discuss long-term tax-efficient investing in more detail. There is no charge for a chat, and it could be life-changing for your finances.
Scott Kingsley, Financial Advisor at Misthos Group.