Venture Capital Trusts better than a pension for high earners?

Changes to the taxation of higher earners in the UK in April will mean that from April 2010, someone earning over £180,000 will potentially be paying 50% tax on the top end of their earnings, whilst only getting 20% tax relief on their pension contributions. This is quite clearly a big step up from paying 40% tax and offsetting this by 40% tax relief on pension contributions. Those earning in excess of £100,000 will also be caught in a slightly different way, as they will lose their annual allowance past this point. This is combined with the worry that they then may pay 40% tax on the income from the pension in the future if they are higher rate tax payers in retirement.

A small proportion of the country is at risk of exceeding the personal lifetime allowance (£1.8m for the foreseeable future), and they will be hit with an additional tax charge of 25% if they do, and then if this wasn’t bad enough, if they have funds in their pension when they die post 75, as they have been drawing the money out in the most flexible and tax efficient manner (Alternatively Secured Income) their children could face a tax bill of between 80-85% of the fund. That level of taxation would make even Dick Turpin blush! So for a select proportion of the country’s wealthier, pensions are becoming less and less appealing.

Could Venture Capital Trusts (VCTs) be the solution?

Venture Capital Trusts are collective investments (similar to a unit trust) that invest in a number unquoted companies (although they can be listed on AIM). As a result of this, the government gives certain tax breaks to investors as they are helping smaller companies grow (who in turn will pay more tax). They are high risk investments, which have put many people off in the past, however the risk attached to each varies widely depending on the areas they invest in. This means they are starting to attract more interest as a pension alternative, and efforts by some companies are being made to reduce the risk of these assets as much as they are allowed.

So what are the tax breaks?
If you were to invest £100,000 into a VCT, once this was entered onto your tax return and submitted, you would receive £30,000 tax back. This 30% relief means you are actually getting growth of around 43% instantly. The investment needs to be held for 5 years to maintain this tax relief, but then this is a much shorter period than you’d need to hold a pension. Unlike a pension, once you have held it for 5 years, you can have 100% of the fund back, tax free. This would in effect mean that you could reinvest the funds into another VCT or a pension, and get the tax relief all over again, but more about that in a minute. The dividends received from the VCT are virtually tax free (as with an ISA), and the growth of the fund free from Capital Gains Tax.

Why are they high risk?
Three of the biggest criticisms of VCTs in the past have been
a) Their exposure to small high risk companies; and those that have provided good returns have been more than offset by those that haven’t.
b) That they needed to be held for long timeframes to see any real growth.
c) Selling the VCT before the before the manager is ready to wind it up has led to poor values, as there is still very little secondary market for VCT shares.

And why are today’s any better?
VCTs have performed reasonably well where they have been held until wind up (typically 10 years), and some VCTs available today now aim to address these issues. This has been done in the following ways;
a) Certain VCTs hold only asset backed investments; e.g. a stately home that is a wedding specialist and hotel. If the business fails, the value of the stately home remains, and the VCT manager will have a charge over that asset to minimise losses.
b) Some VCTs are being set up with specific timescales for exit; typically 5-6 years, as this is when they realise investors will want to get out, and potentially reinvest for more tax relief.
c) Offering sensible buyback facilities so that you are guaranteed to have a secondary buyer.
d) A VCT has up to 3 years to get 80% of the funds into qualifying investments, so some are using discretionary managers or hedge funds to manage the money in the lead up to this; thus providing good returns from day one.

Pension changes in the future?
There are more significant changes to the pension and retirement market scheduled for 2012. If we get a different government next year, as looks likely, there is a lot of talk that these changes will be overhauled, and the pension and retirement market will again be altered dramatically. Whether these materialise or not, a VCT is a great way of benefiting from tax relief now, whilst leaving your options open in the future.

What next?
The minimum investments are typically only around the £5,000 mark, so these are not reserved only for the high earners. If you would like to look more seriously at a VCT investment, speak to a suitably qualified adviser who can talk you through the pros and cons.

Written by, Charlie Reading Dip PFS
http://www.e-fficientportfolio.co.uk/
Tel; 01536 772077