ISAs and pensions should be the first port of call for tax-efficient investing but for high earners who have maxed out those vehicles, venture capital trusts (VCT) are a natural next step.
Nicholas Hyett, investment manager at Wealth Club, said: “VCTs appeal for a couple of reasons. Obviously 30% income tax relief upfront is the shop window. Say you put £10,000 into your VCT today, you get £3,000 back from the tax man straight away.
“But I think the more valuable tax break if you're in that higher earning bracket is the tax-free dividends – the ability to withdraw money from your investments without facing higher additional rate tax on it.”
The classic VCT investor would be someone at their peak earnings potential, from their late forties through to retirement, as well as people who retired within the past five to 10 years, for whom tax-free dividends are particularly valuable.
The average age of Wealth Club VCT investors is 58 and the biggest age group by amount invested is 56-65, yet Wealth Club’s clients range in age from 18 to 103.
“VCTs are probably the starting point for what you might call regular high earners, people who are in the six figures but not mega earners,” he said. This might include head teachers, senior civil servants and bankers.
Frozen tax allowances have pushed more people into the additional rate tax bracket, he noted, which involves a 45% levy on earnings over £125,140.
Furthermore, people older than 55 who have already taken income from their pension are only permitted to contribute up to £10,000 a year or 100% of their earnings, whichever is lower, into their pension pot. This makes other tax-efficient savings vehicles such as VCTs appealing.
Investors must hold onto VCTs for five years to qualify for tax relief. “There is essentially no secondary market for the shares, so when you come to sell your VCTs after at least five years, you are likely to be selling them back to the VCT manager,” he explained.
Most VCTs have buyback programs, often at a 5% discount to net asset value (NAV).
Another peculiarity of investing in VCTs is that, unlike open-ended funds and investment trusts, they are capacity constrained, so they raise a target amount each year then shut and some managers don’t fundraise every year.
Most VCTs launch an offer in September or October, sometimes with early bird fee discounts. By late March, the popular trusts are often shut. “Some years when the market is really flying, you might find stuff closing in January or February,” he noted.
Mobeus shut its two VCTs as early as October 2024 having raised £90m in 45 days, but that is unusual.
Investors often wait until the end of each tax year to allocate money to their ISAs but with VCTs, “there is a reward for going early”, he stressed.
Taking tax-efficient investing one stage further with EIS and SEIS
Enterprise investment schemes (EIS) and seed enterprise investment schemes (SEIS), which provide seed capital to start-ups, attract a different demographic, namely very high earners.
Taxpayers who earn £260,000 or less can put 100% of their earnings of £60,000 (whichever is lower) into their pensions and obtain full tax relief; but for people earning above that threshold, their annual limit is reduced by £1 for every £2 of income above £260,000. Therefore, somebody earning £280,000 would only get tax relief on £50,000 of pension contributions each year, according to MoneySavingExpert.
People earning significantly above that amount would have their tax relief curtailed further, so may wish to use additional savings vehicles.
EIS have the added advantage of large allowances. Investors can put up to £1m in EIS per tax year (£2m if at least £1m is invested in knowledge intensive companies) and claim 30% income tax relief. That compares to a £200,000 cap for VCTs and SEIS. There is a higher minimum investment for EIS, starting at £25,000 per fund compared to as little as £3,000 for some VCTs.
Both EIS and SEIS would appeal to people with a large capital gains tax (CGT) bill, Hyett said; perhaps someone who has sold their business or a buy-to-let property.
Investing capital gains made from the sale of other assets into EIS enables people to defer their CGT bill for the life of the EIS investment.
Furthermore, capital gains reinvested into SEIS (but not EIS) are granted up to 50% CGT relief. SEIS also benefit from up to 50% income tax relief.
EIS and SEIS both offer tax-free growth and loss relief (i.e. investors can offset any losses against their income for tax purposes) and they can be passed onto dependents free of inheritance tax, which is “a nice perk in a world where pensions no longer are [IHT free]”, Hyett said.
However, the major draw for investors in EIS and SEIS is not tax relief but the promise of exponential returns. Most EIS managers aim to treble investors’ money over five years. “SEIS probably targets more like five times, maybe 10 times if you've got a manager who’s particularly punchy.”
Most EIS invest in about 10 companies so they are quite concentrated and because the underlying companies are not listed, there is no guaranteed route to exit. In practice, this means investors usually hold EIS-qualifying investments for a minimum of five to seven years. With SEIS the holding period can be anything from seven to 15 years, Hyett explained.