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A new investor’s introduction: what are tax efficient investments?
The phrase ‘tax efficient investments’ might sound bewilderingly complex. It shouldn’t. As HM Revenue & Customs used to remind us “tax doesn’t have to be taxing”; and nor does tax efficient investing.
Experienced investors with extensive portfolios may utilise a range of initiatives to structure their investments - but this does not mean tax efficient investing is exclusively the preserve of this investor group.
In fact, anyone who pays tax can access tax relief through investing in UK businesses; an activity that also represents an exciting opportunity to get involved with a new venture.
Tax efficient investing involves capitalising on incentives introduced and endorsed by the UK Government and is neither complex nor onerous (we published a post that shows the process of - and how easy it is to - claim one of the reliefs as an investor).
And so the purpose of this post? Acknowledging and explaining the relationship between risk and equity investing before explaining just how tax efficient investing may appeal to you.
The nature of equity investing
Investments in early-stage companies with limited trading history are often classified as a risky asset class. As with all investment products, the way in which they are described is regulated and suitable explanatory text must accompany financial promotions.
Examples of this that you may be familiar with include the strapline “capital at risk” and the summary sentence “the value of your investments can go down as well as up, so you could get back less than you invested”.
It is important to understand the nature of risk in relation to equity investing. However, understanding risk should not translate to wholesale avoiding equity investing.
Other financial products may protect your capital, but this does not make them ‘risk free’.
Although your capital is protected, often by Government-backed guarantee, these products often grow at a rate below the headline rate of inflation. The impact of this is best articulated in Royal London’s report The Curse of Long Term Cash, published earlier this year:
“What we have called the curse of cash can be summed up in an apparent paradox. In the short run, cash is the safest asset class. In the long run, it is the riskiest.”
Whilst risk cannot be eliminated from equity investments, it can certainly be managed.
You, as an investor, can manage your exposure to risk through a range of steps.
Firstly, you should thoroughly research the company in which you are considering investing - try to understand their business model and think, based on your experience, about whether their assumptions are realistic.
Secondly, you should seek to assemble a portfolio of diverse investments. This reduces your exposure to risks that affect specific sectors or geographies.
Online platforms generally have much lower minimum investment levels than more traditional investment routes - this assists your pursuit of diversification. Diversification can be achieved within a £1,000 investment portfolio, through making a series of seven or eight investments, each of between £100 and £200.
Thirdly, one of the key features of tax efficient investing is that your exposure to risk can be mitigated through the tax relief available to you. Tax relief can often reduce the true cost of your initial investment and, depending on the investment scheme, can also offer what is termed ‘downside protection’.
Downside protection enables you to claim back a proportion of your loss should your investment be sold for less than you paid for it.
Tax efficient investment schemes
Tax efficient investment schemes are introduced and endorsed by the UK Government because they assist companies attract the capital they require to execute their growth ambitions. Two of our favourite schemes are the Enterprise Investment Scheme (EIS) and the Seed EIS (SEIS).
- The Enterprise Investment Scheme (EIS)
The EIS is an established HMRC scheme that offers a range of incentives that are valuable to first-time investors and seasoned, professional investors alike.
Investing in a business that is EIS accredited entitles you to reclaim 30% of your investment in income tax relief, provided you hold the investment for a minimum of three years and have paid sufficient income tax.
This means if you invest £500, you will be eligible to reclaim £150 in income tax relief.
- The Seed Enterprise Investment Scheme (SEIS)
The SEIS is the EIS’s younger sibling. Businesses just starting out qualify for SEIS accreditation and investing in one of these entitles you to reclaim 50% of your investment in income tax relief, again provided you hold the investment for a minimum of three years and have paid sufficient income tax.
As such, if you invest £500, you will be eligible to reclaim £250 in income tax relief.
Importantly for investors, both EIS and SEIS investments also offer downside protection. Essentially, if your investment is sold for less than you paid for it, you can claim loss relief at your prevailing rate of income tax.
By way of an example, if you are an additional-rate taxpayer who invests £500 in an EIS-eligible company that subsequently ceases trading, you can claim loss relief on your financial loss.
Assuming you claimed tax relief of £150 on your initial investment, your financial loss will be £350 and you can claim back £157.50. Despite the value of your investment falling to zero, your financial loss would be considerably less than your initial investment of £500, at just £192.50.
And the best thing about all of this information? It really is just the tip of the iceberg.
Both EIS and SEIS investments offer a range of further tax incentives, including exemption from inheritance tax after just two years, whilst there are numerous other investment schemes offer similar incentives.
To find out more about the investment opportunities open to you as an investor and how you can simultaneously reduce your tax bill, grab your copy of our free downloadable guide.