Tax-free saving beyond Isas and pensions

By now you've probably realised that one of the most important factors in ensuring you have a comfortable retirement is to control your costs. That includes tax.

We've already discussed the benefits of the two most common tax shelters individual savings accounts (Isas) and pensions.

But there are other types of investments out there that can save you tax too. Some are very safe, whereas others are high risk and only really suitable for sophisticated investors. So what are they? And which will suit you?

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National Savings & Investments (NS&I) very low risk

This is probably one of the safest places for your cash. Money invested here is essentially lent to the government. You don't have to worry about whether or not you'll get your money back.

NS&I offers a number of tax-free investments with varying degrees of appeal. It offers a cash Isa, but you will probably get better rates from most banks and building societies.

Premium bonds are another option. You can invest up to £30,000 in these, but you are not guaranteed any specific interest rate as your bonds are placed in a monthly lottery. The interest rate on the fund of premium bonds is currently 1.5% and your chances of winning a prize are 24,000 to one.

You could win a maximum prize of £1m, but unless you have the maximum amount invested (or you are unusually lucky), you are likely to be able to get a better return elsewhere.

So a better alternative might be fixed-rate savings bonds. These pay a tax-free fixed rate of interest for three or five years. You can invest £15,000 in each issue. Even better are index-linked savings certificates. Here you can invest for three or five years, and your money will keep pace with the retail prices index, and give you a real (after inflation) return on top. Again you can invest £15,000 in each issue.

Both these types of bonds have been so popular with savers that there are currently no issues on sale. But there's a good chance that new issues will come on to the market again in the future. If you don't like risk, keep an eye out for any new issues.

Children's bonds are another tax-free investment. £3,000 can be invested in each issue (currently five years) and are tax-free for both the parent and the child. They cannot be held beyond a child's16th birthday, and there is a penalty (90 days interest) for cashing them in early.

Friendly societies one to avoid

You don't tend to hear about these products much. But you can invest £25 a month (or £270 as a lump sum) tax-free with a friendly society each year. Payments are usually invested in a with-profits fund (a fund that aims to give you steady growth each year by saving up returns in good years and adding them to your fund in bad years) for a period of time (say,ten years). This fund tends to be invested in a wide spread of assets (shares, bonds, property, cash) and pays out a tax-free lump sum on maturity.

We'd stay clear of these investment products. The tax breaks are not that worthwhile and the charges tend to be very high: annual expense ratios of 3% are verging on the extortionate, meaning that it's hard to get back much more than you put in.

Venture capital trusts (VCTs) high risk

VCTs invest in young companies that need money to grow their business. These companies are not usually quoted on the stock exchange, although VCTs can invest in companies that are listed on London's Alternative Investment Market (AIM).

VCTs invest in a number of qualifying companies (the rules are set by the taxman). The shares of VCTs themselves are listed on the stock exchange. As they are investing in younger, unproven companies, VCTs are more risky than normal unit and investment trusts.

What can make VCTs attractive to investors is the generous tax savings on offer. You can subscribe for up to £200,000 of new VCT shares a year. If you hold the investment for five years, you can get 30% tax relief on the amount you invest (as long as you pay enough income tax in the first place). Dividends and capital gains are also tax free.

If you sell your VCT investment before the five years is up, you will have to pay the tax relief back. There is also a risk that the VCT could fall foul of some of the rules, which would also mean that the tax relief would be clawed back by the taxman (for example, if a VCT looks as though it was set up primarily to avoid tax rather than to invest in young companies, it may run into trouble further down the road).

The tax breaks on VCTs are unquestionably attractive. But the risks are also high. VCTs can be illiquid if you need to sell your investment early, you can do it through a broker, but you may not get a very good price.

They can also be expensive: initial charges and annual management fees (sometimes performance fees too) can be a lot higher than with unit or investment trusts. So make sure you read the prospectus closely before you even consider investing.

Enterprise investment schemes (EIS) high risk

These are similar in some ways to VCTs in that they support small, young companies. If anything, they are even riskier than VCTs because they invest in even smaller companies.

An investor can invest up to £1m in a qualifying EIS company or fund. You must either hold the investment for three years or the company must trade for three years after the investment was made for you to get the 30% tax relief on the amount you invest (subject to having a big enough tax liability in the first place). You can also carry back relief to the previous tax year, subject to certain conditions.

EIS investments offer plenty of tax avoidance and planning opportunities for wealthy people. For example, if the investment is sold at a loss, the investor can offset this loss against any gains. Also, capital gains made elsewhere can be deferred by investing them in a qualifying EIS either one year before or three years after a gain is made. Providing that you hold the EIS investment for long enough, you will not pay capital gains tax on the disposal proceeds. However, any dividends received cannot be sheltered from tax.

The major drawback with EIS investments is that they are difficult to sell. They are not traded on the stock exchange, so you can only get your money back when the investment is sold. This makes them risky investments that are only suitable for sophisticated investors, and even then only as a small part of a diversified portfolio.

As with VCTs the cost of investing can be very high. So again, it's important to read the prospectus to find out about all the risks and costs of a particular EIS. Talk to your broker about how and where you can invest.

Overall, VCTs and EISs are primarily for investors who have unusually large portfolios those who are at the stage where they can save enough to exhaust both their annual Isa allowance and annual pension allowance.