As a word couplet with saver sex appeal, 'Tax Free' has no equal But it often presages titillation, not satisfaction
Here are six tax traps:
1) It's the whole tax take that counts
The tax position of the particular product or wrapper you are buying is irrelevant on its own. What matters is the total tax paid as cash flows back from the underlying investment into your hands.
Unit trust funds are untaxed. But insurance funds are taxed on income and capital gains at the basic rate (22%). So, to level the playing field , income and capital gains derived from unit trusts are fully taxed in the hands of a private investor. But he pays only higher rate tax on distributions from insurance funds.
The general effect is that all income and capital gains on both these types of fund are fully and equally taxed at some point on their path into the hands of the private investor. But your adviser, in his enthusiasm to make a sale, may sometimes imply that an insurance fund has a tax advantage ("you pay no more tax" or "you only pay higher rate tax").
In fact, if we want to be picky, insurance funds are at a tax disadvantage. They pay tax immediately (as opposed to unit trusts where the tax is deferred until the investor takes a distribution). And they do not use the private investor's Capital Gains Tax allowance.
2) Mixing apples and oranges
If you buy a washing machine you pay VAT. If you buy a dog you don't. The fund industry would say something like this: "Dogs are warmer and more affectionate than washing machines, and they hurt less when you walk into them. They don't wash very well, but they have the advantage of being exempt from VAT. This gives them an advantage over washing machines, which bear tax at 17.5%."
It's rubbish isn't? But you will see stuff like this over and over again in promotional literature. It's exploiting the sex appeal of 'Tax Free'. Sex sells.
3) Absence of tax is not automatically clever
When your car travels its first 1,000 miles without breaking down you may feel some slight relief, but it's no more than you expect. So why should the absence of tax on fundamentally non-taxable transactions be a selling point?
Some insurance bonds allow you to withdraw 5% of your money each year for 20 years 'tax free'. You might question why getting your own money back untaxed is so special. And of course it is not. Capital is never taxed (except on death). You get the same effect by putting your money under the mattress and taking out 5% each year.
Students of hyperbole may admire the following from an IFA's magazine (referring to your choice not to withdraw your annual 5%); "If you defer taking your income, your unused tax-free allowances from earlier years can be carried forward for up to 20 years".
4) Sometimes advisers just get it wrong
Tax is complicated.
From April 2004, a fund comprising more than 60% bonds and held within an ISA is treated as a bond fund. It receives a 20% tax credit on the whole amount of the income.
Since the 40% equity portion, if held alone, would not qualify for this credit this seemed to be a tax advantage, and the commentators said so (see sidebar). There was a big marketing push on these funds - given the catchy name of 'distribution funds'.
An investment bank, among others, did the sums properly and showed that the tax credit was only a refund of extra tax withheld by the fund on its distributions.
5) Regulations are not forever
The Chancellor proved this in 1997 when he annexed 20% of the value of all equity income in pension funds (and PEPs and ISAs) by removing the refund of dividend tax credits.
So any tax plan requiring a continuing status quo requires, at the least, a certain scepticism.
6) Sometimes promotions just get it wrong
The regulator, and indeed the public, will tend to skate over the tax statements. So more inaccurate stuff gets through, particularly when it's camouflaged with hyperbole.
Here's something a long time ago (2003) from a popular fund group we won't name. We are sure it's all different now:
"With a fixed interest element which must never fall below 60%, under current regulations, the Inland Revenue treats the income paid by the Fund as interest rather than dividend income. As a result the Fund does not attract advanced corporation tax (ACT)."
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