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John Glencross: What EISs and VCTs can bring to a retirement portfolio

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Enterprise investment schemes and venture capital trusts have increasingly become part of the retirement planning conversation over recent years.

Why? Because since 2011, pensions have been subjected to almost yearly cuts to the amount of tax relief they provide. These measures have targeted high net worth individuals in particular. New restrictions have ranged from the tapering of the annual allowance to the reduction in the lifetime allowance to £1m.

As such, high earners have turned to other tax-efficient investments as retirement-friendly homes for their excess savings. EISs and VCTs provide a complementary set of tax reliefs and the potential to realise some significant capital gains. In addition, they suffer few of the drawbacks of pensions, such as having to lock up your money until you are 55 and needing to take the bulk of the proceeds as taxed income.

But if pensions are not perfect, neither EISs nor VCTs should be considered an outright substitute for them. For one, the 30 per cent tax relief they provide is contingent on the investor having already paid that amount in income tax elsewhere. The same is not true of pensions, where tax relief ranging from 20 per cent to 45 per cent is provided on contributions, regardless of what tax has been paid (though the amount that can be contributed has been severely restricted, as mentioned).

EISs and VCTs are also defined by investment in a specific asset class: smaller unlisted UK companies (though AIM-listed companies are permitted). Pensions, on the other hand, have an extremely broad investment universe.

So no sensible person would advise completely substituting a pension with an EIS or VCT. But within a balanced retirement portfolio, there is plenty of space for them. Let’s have a look at how they compare in more detail:

Income tax relief

EISs and VCTs provide 30 per cent income tax relief on investments of up to £1m and £200,000 annually, respectively. Investments must be held for three years for EISs and five years for VCTs. With EISs, investors also have the ability to carry back to address liabilities from the previous year.

“Dividends are rarely, if ever, paid to EIS investors. Returns usually come in the form of a tax-free capital gain.”

No other tax-efficient investment provides this level of income tax relief outside of a pension. For some higher earners who, owing to annual allowance tapering, may only be able to invest £10,000 a year into a pension (albeit receiving 45 per cent tax relief on this small amount), EISs and VCTs have become almost a default option.

Capital gains tax

There is a level playing field here. Gains in pensions, EISs and VCTs are all paid free of CGT. However, EISs have an additional and unique feature: CGT deferral. This allows for gains realised on other investments to be invested in an EIS fund without first having paid any CGT owed, allowing them to generate new gains on which CGT would not be owed.

But it is only a deferral, so the original CGT amount would be owed when the EIS gains were realised; though the amount owed could be reduced if it could be offset against losses accrued elsewhere.

Tax treatment of income

Up to 25 per cent of a pension pot can be taken as tax-free income but the remainder is charged at an investor’s marginal rate of income tax.

VCTs usually pay all of their investment returns to investors in the form of dividends, which for these vehicles are tax-free. This makes VCTs particularly attractive to investors who need income in retirement.

Dividends are rarely, if ever, paid to EIS investors. Returns usually come in the form of a tax-free capital gain.

Protection against losses

Another unique feature of EISs is loss relief. This means a maximum loss for a 45 per cent taxpayer on an EIS investment would be 38.5p in the pound – when also taking initial income tax relief into account. This is applied at the level of an individual investment, rather than across an EIS fund portfolio.

So nine out of 10 investments in a portfolio could make money, giving a net positive gain, but loss relief could still be applied to the single investment that did not. Loss relief can be taken against liabilities in the year the loss occurs, can be carried back against the previous year’s liabilities or treated as a normal capital loss.

Inheritance tax

VCTs are not exempt from IHT but EIS investments generally are if held for two years. For pensions, beneficiaries can usually receive a person’s pension funds without having to pay IHT, though they may have to pay income tax at their marginal rate on the sum inherited, depending on whether the individual was older or younger than 75 when they died. If older, income tax is usually payable.

John Glencross is chief executive of Calculus Capital

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  1. The primary element which EISs and VCTs can bring to a retirement portfolio is a level of risk for which many investors don’t have a corresponding appetite. The point about Loss Relief is valid enough, but there’s still a much higher risk of loss (or at least severely depressed gains) than with more traditional investments made via a conventional pension plan.

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