Our Guide to Tax Efficient Investing
The quote “Don’t let the tax tail wag the investment dog” means don’t make investment decisions solely based on tax considerations. Nevertheless, it is certainly sensible to invest in a tax-clever and tax-efficient way.
What is meant by a tax-efficient investment is often quite difficult to define. What is viewed as being tax-efficient for one individual may in fact be quite inefficient for another.
For anyone considering making an investment there are several key tax related issues to consider, what is the exit tax at the end of the investment? Am I better to have the return taxed as income or capital gains? What rate of tax do I pay on my returns? Should I invest as an individual or through a company structure? The tax treatment of investment returns can vary from 33% Capital gains tax to 41% Exit Tax and even up to 54% income tax.
Offsetting Capital Losses
Let’s take for example a client who has suffered capital losses in recent years (this applies to many people who suffered losses on property or bank shares), this type of client ideally wants to generate a return liable to capital gains tax so that their existing losses can be fully offset against future gains. This offset couldn’t be achieved if they invested in a managed fund for example, which is liable to exit tax or a Deposit which is liable to DIRT.
Given that the return on cash deposits is currently so low, it might be viewed as uneconomical to leave savings sit in a deposit account. In addition, the DIRT rate is now 39% and for some individuals, interest income is also subject to PRSI at 4% which brings the effective tax rate to 44% on deposit interest. It’s also worth noting that DIRT is payable on the very first cent of deposit income which is earned, while capital gains tax investments come with an annual exemption. Every individual has an annual CGT exemption of €1,270 (€2,540 if it’s a joint investment by a couple), this means that the first €1,270 or €2,540 earned each year is Tax free. Are you utilising this exemption?
Personal v Corporate Investing
Another issue to consider is whether an investment should be made by an individual directly, or whether they might consider setting up an investment company to make the investments.
For individual investors, investment income may be subject to a rate of income tax of 54%, compared with a corporate entity that will pay corporation tax on non-trading investment (examples include deposits, shares, stocks, rental income) income at 25%, plus potentially an additional close company surcharge (a surcharge of 20% is payable on the total undistributed investment and rental income of a close company), which will bring the effective rate of tax to 45%.
While the tax rate paid by the company is lower than an individual, you are then faced with the issue of getting the money out of the company in a tax efficient manner.
Gross Roll Up of Investment Returns
Lump sum investment and savings plans issued after 1st January 2001 benefit from the Gross Roll Up regime i.e. all income and gains in the life fund accumulate gross, with a ‘deemed’ tax charge on any growth only on each 8th plan anniversary.
When part or all of the funds are withdrawn, an exit tax will be deducted from the ‘profit’ element of the withdrawal, with a credit for any tax paid on any previous 8th year anniversary. Where the plan owner is a company the rate of exit tax was reduced to 25% with effect from 1 January 2012.
Life Assurance Investments & The Close Company Surcharge
The effect of the Gross Roll Up regime is that a company can defer tax on the investment until at least the 8th anniversary of the contract, thus allowing the company to compound investment earnings without those earnings being reduced by taxes during this period. This should lead to accelerated investment growth.
Another advantage is that the life company with whom the funds are invested is responsible for the deduction and payment of exit tax. The net amount is payable to the investor.
The Power of Compound Returns
One of the most tax efficient investments may people will make is contributing to their pension. All investment returns that are made within a pension fund are completely tax free, and the compounding effect of tax-free growth over time is very powerful. In addition, if you are a higher-rate taxpayer, you also get 40% tax relief on any contributions paid into a pension, subject to certain limits. The most tax efficient pension contribution is a company or employer contribution, because such a contribution escapes income tax, corporation tax, PRSI and USC. Personal contributions and AVCs qualify for income tax relief at marginal rate but nothing else.
Needless to say, tax is just one box that needs to be ticked when considering whether or not to invest in a particular product. My advice is simple – tax is a cost that you can’t ignore, however prior planning can often help to avoid future pain. While you shouldn’t let the tax structure be the main factor which influences your investment decision, it certainly warrants due consideration.
Gerard O’Brien LL.B LL.M CFP® QFA is a Certified Financial Planner and the Owner of Heritage Wealth Management, a Financial Planning practice based at 27 Cook Street, Cork. For more information, contact Gerard at firstname.lastname@example.org www.heritagewealth.ie
Disclaimer: All data and information provided within this article is for informational purposes only. Heritage Wealth Management Limited makes no representations as to accuracy, completeness, suitability, or validity of any information and will not be liable for any errors, omissions or delays in this information or any losses, injuries, or damages arising from its use.