VCTs: an alternative to pensions for higher earners?

Over a decade ago, a high earner could invest up to £255,000 per tax year in a pension and get a significant percentage of that back in tax relief.  

Those days are gone. 

The tax benefits offered by pensions have since been gradually eroded by successive governments eager to collect more tax – particularly, it would seem, from high earners.

Now the annual pension allowance is £60,000, reduced to a mere £10,000 for those with income of £360,000 or more in a year.

How else might one put money aside tax-efficiently for retirement?

What options are there for those who want to invest tax efficiently, but have already used up their pension allowances?

One option for experienced investors could be one that is surprisingly under-publicised: Venture Capital Trusts, or VCTs as they’re commonly known.

VCTs specialise in investing in small, often unquoted companies. Most of the companies in which VCTs invest are young. This usually makes them more risky than larger companies.

The similarities to pensions are upfront tax relief and tax-free growth. In addition:

1. Any dividends a VCT pays are tax free. Note, dividends are variable and not guaranteed.
2. With VCTs, the annual allowance is generous and uncomplicated: £200,000. When you invest you could also receive up to 30% income tax relief. 

Remember, tax rules can change and benefits depend on circumstances.

The value of tax-free dividends

The potential for tax-free dividends could be especially attractive, considering the tax-free dividend allowance has now halved and will be halved again from 6 April 2024. 

Regardless of the allowance, to receive £1,000 in your pocket from a VCT you need a £1,000 dividend payment – there is no tax and no need to declare it on your annual tax return. Compare this to a "normal" investment: as an additional-rate taxpayer you would need a dividend cheque for nearly £1,650 to receive £1,000 after tax (under current rules).

Put another way, an additional-rate taxpayer would have to receive a gross dividend of more than 8% from a unit trust or investment trust (taxed), to match the income from a corresponding 5% VCT dividend (tax-free). 

No lifetime cap on VCT investments

Whilst there is a £200,000 limit on how much you can invest in VCT tax efficiently each tax year, there is no lifetime limit. Note that to retain the tax reliefs you need to hold each new VCT investment for at least five years.

Many VCTs offer a dividend reinvestment scheme – which could be useful if you don't want income now, but are planning for future retirement. The shares bought should in most cases qualify for the 30% upfront tax relief and count towards your annual VCT allowance.

Where else do pensions and VCTs differ?

A significant difference between pensions and VCTs is where they are invested. A pension such as a Self-Invested Personal Pension (SIPP) generally allows you to invest in shares and bonds of large companies in the UK and overseas. VCTs instead invest mainly in small UK companies, so they are considerably riskier – the tax breaks aim to somewhat mitigate this, to encourage investment into young, dynamic British enterprise. 

Another difference is that pension funds can be easily realised once you reach retirement and are designed to provide a regular retirement income. By comparison, whilst VCT dividends could provide an attractive tax-free supplementary income, it’s less easy to cash in a VCT than it is to draw down a pension and dividends are variable and are not guaranteed. The market for VCTs is also relatively illiquid, meaning there aren’t as many buyers and sellers for VCTs as for other types of shares – although some VCT providers do offer share buyback from time to time.

Lastly, VCTs form part of your estate upon death, whereas a pension generally falls outside it; so, the value of your VCT investments could incur inheritance tax (IHT). 

It is important you read the Risks and Commitments to find out why VCTs may not be a consideration for everyone.

Should you be in any doubt, please seek professional financial advice.

If inheritance tax (IHT) mitigation is more of a priority, you might consider AIM ISAs or IHT portfolios. Investments under the EIS and SEIS schemes can also be IHT-free.