Bigger picture

When it comes to selecting investments, the public are right to be confused. The internet offers many strategies ranging from sensible to crackpot, simple to mind-boggling.

A subject often neglected is how to choose the right tax vehicles for your investments. Getting it wrong can create a drag on returns, or worse. Although, while choosing the right vehicles won't make up for a poor investment, it has the power to boost returns. It's possible to make this complex. But a three-tiered structure meets most circumstances:

• Because of their tremendous tax-breaks, ISAs are usually the preferred home for the first part of an investment, sheltering the money from income tax and capital gains tax (CGT). They're very simple and easy to access. Unfortunately, there's a limited annual contribution allowance (£11,520 this year).

• The second tier is often a portfolio of shares or (more likely) unit trusts. In terms of tax efficiency, this element serves to make use of a different tax break: the CGT allowance, which enables gains of up to £10,900 a year, without any tax to pay.
  This element has a natural threshold - usually around the £250,000 level per person. On that amount, (assuming a reasonable return of roughly 4 per cent over and above dividends) the allowance will be used to its maximum extent, providing crystallization, and reinvestment is undertaken each year. These annual sales are often used to fund each year's ISA allowance, so-called 'bed and ISA-ing'.

• The third part might be an investment bond. This plan allows investment into the normal range of funds; the key difference is that instead of higher and additional rate tax being payable year-on-year, it can be deferred indefinitely until the gain is realised. At that point, potentially many years down the line, there are several options to time, control and minimise the tax payable.

This three-tiered arrangement ignores pensions - which, arguably, are in a category apart - and doesn't cover more exotic arrangements such as venture capital trusts and AIM-share portfolios (but, for most, the associated investment risks make them the exception).

The decision about how to allocate the chosen investment funds between the vehicles can add a further layer of tax efficiency as some fund types are more tax efficient depending on how they are held.

• The ISA is the preferred home for those funds that hold 60 per cent or more in fixed interest holdings. This allows fuller reclaim of tax paid at source on the underlying holdings. Second, the ISA will hold funds that are fully equity based and expected to give the highest returns, so tax sheltering the largest degree of growth.

• The unit trust element is preferred for funds that hold a high equity element but with a lower than average yield, which helps to minimise income tax on dividends for higher-rate taxpayers.

• The investment bond is the preferred means for funds with a high equity weighting and strong dividend yields (which have not already been accommodated in the ISA).

None of this is intended to be prescriptive. There are alternative approaches to portfolio construction, and every client is different. In particular, this is for individuals rather than trusts or corporate investors.

What I hope it demonstrates, however, is that there is very much more to investing than simply choosing where to invest. A good adviser will look to use all of the available allowances, maximising tax efficiency at each and every stage of portfolio construction.

Scott Gallacher is a director at Rowley Turton

He writes the regular IFA comment in Private Client Adviser