Diversification in Financial Planning

Diversification is at the heart of good long term financial planning, both in the products you use and the investments you make. In this blog post I look at the benefits of combining different financial products to meet your long-term objectives in a tax efficient way.

Typically, the main objective of your investment portfolio is to achieve the highest possible return in line with your attitude to risk. Tax will always have an impact on this return. Using the principle of diversification when structuring your investment portfolio means you can take advantage of any tax allowances you are entitled to. This means you can maximise the returns of your investment portfolio.

Each year there are various tax allowances and exemptions that you can use to make your investment portfolio more tax efficient. Used consistently over a long period of time, you can save substantial amounts of tax.

Your investments can be wrapped or unwrapped. A tax wrapper (which is a vehicle that can be wrapped around a portfolio of assets) determines how the gains and returns of the investments are treated for tax purposes. An ISA and a pension are both examples of a tax wrapper.

As financial planners, we look to make use of your available tax allowances and exemptions each year to reduce your current and future tax liabilities. In the following examples, I show how using the ISA and pension tax wrappers, and unwrapped investments can achieve this:

• Individual Savings Account (ISA)

If you are over the age of 16 (or 18 for a Stocks & Shares ISA), you can contribute up to £20,000 into an ISA in the 2021/22 tax year. If you have children under the age of 18 you can also contribute up to £9,000 into a Junior ISA. Once in the ISA, any growth, dividends or interest is tax-free. Withdrawals from the ISA are also tax free.

Each year we look to make use of our clients’ ISA allowances, and when taking into account investment growth you can build up substantial funds within your ISA. Funds held in an ISA can then be used to supplement income in later life in a tax efficient way, or they can be used for one off expenses.

• Pension

Depending on your earnings, the annual allowance for a pension in the 2021/22 tax year is up to £40,000 gross. Once in the pension wrapper, any growth, dividends or interest is tax-free.

Not only are funds within a pension held in a tax-free environment, but contributions are also subject to tax relief as well, at an individual’s highest marginal rate of income tax (20%/40%/45%). A pension can be a very effective retirement savings vehicle.

While pension funds are not accessible until age 55 (57 depending on your date of birth), throughout your life you can build up a substantial fund to draw on in retirement. Or alternatively, if you have also built-up funds across a range of investment products, you may not need to draw from your pension and you can pass it on to the next generation without it being assessed for inheritance tax.

• Investment Account

There is no limit to how much you can put into an investment account. Income from the assets held in the investment account may be subject to dividend or income tax. Any growth in the value of the assets held may be subject to capital gains tax once sold.

In the case of an investment account, you can use the allowances as follows:

• Savings Allowance – The savings allowance for the 2021/22 tax year is £1,000 for basic rate taxpayers and £500 for higher rate taxpayers. This means you can earn interest on cash balances up to either £1,000 or £500 depending on whether you are a basic or higher rate taxpayer without paying income tax.
• Dividend Allowance – The dividend allowance for the 2021/22 tax year is £2,000. This means that you can earn dividends up to £2,000 without them being liable for tax.
• Capital Gains Tax Allowance – The capital gains tax exempt amount is £12,300 for the 2021/22 tax year. This means that you can realise gains of up to £12,300 without incurring a tax charge.

The examples above show how splitting your money between different investment products can reduce your tax liability both now and in the future. Structuring your investment portfolio using both wrapped and unwrapped investments also gives you flexibility when you come to draw an income from your funds in retirement.

As financial planners, we see a broad range of client circumstances and there is no one size fits all approach, but generally making use of your available tax allowances and exemptions where possible in each tax year is a sensible starting point for most clients.

Where a client’s circumstances become more complex, there are a broad range of additional product wrappers that we can use. These include, but are not limited to, onshore bonds, offshore bonds, Venture Capital Trusts, Enterprise Investments Schemes and Seed Enterprise Investment Schemes. The suitability of each of these products depend on a client’s circumstances, objectives and appetite for risk. These products are not suitable for the majority of investors and are considered high risk, they can invest in relatively new startup companies and may be subject to time constraints to benefit from tax. However, when used appropriately, they can help to diversify a client’s portfolio in a tax efficient way and help them achieve their financial planning objectives.

If you would like further information on anything covered in this article, please get in touch.

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation which is subject to change. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. The Financial Conduct Authority does not regulate Tax Advice.