Money tip #26 – Never make an investment just for tax reasons

One of the golden rules when investing is never make an investment for tax reasons alone.

An investment should only be entered into on the basis that it suits your personal and financial circumstances and that you understand the risks associated with it.

For example, Venture Capital Trusts (VCTs) offer attractive tax reliefs on any investment made into them. Income tax relief at 30% is available to be set against any income tax liability that is due (up to a maximum of £200,000 per tax year), whether at the lower, basic or higher rate. There are also Capital Gains tax reliefs available.

On the face of it VCTs will seem particularly attractive to high rate tax payers. But, a VCT is designed to encourage individuals to invest indirectly in a range of small higher-risk trading companies whose shares and securities are not listed on a recognised stock exchange. Consequently it is a high risk investment with the potential for you to lose some or all of the capital you originally invested. I have personally met people who have made investments into VCTs pre-credit crunch. The problem for these investors now is that the small start-up companies which their VCTs invested in have been hammered by the drought in credit availability. Consequently, the value of these investments have plummeted by as much as 53% so wiping out any initial tax incentive. VCTs are still a valid investment for the right portfolio/person but there are some people who have made such an investment and are now counting the cost. I have heard a number of people say ‘God that was a bad idea, I only did it for the tax relief’. They were so obsessed with reducing their tax bill they were blinded to the risks of the investment itself. Yes these investments should hopefully recover at some point but there is no guarantee.

Obviously my point is not to be confused with sensible tax mitigation. For example instead of putting money into a savings account you might put it in an ISA where you can have instant access, receive a better rate of interest which is paid tax-free. The underlying investment is still cash but you have simply mitigated the tax liability.

So if you find yourself making an investment purely for tax reasons then think twice and seek financial advice.