Inheritance tax is heinous, but avoiding it could be a bigger disaster
They say nothing in life is certain but death and taxes, but I propose to add a third to the list: investors doing everything imaginable to avoid taxes.
The bigger the bite HMRC wants, the heavier the hustle to shield hard-earned assets. Thanks to Labour dragging pensions into the inheritance tax net, it is now a stampede.
Yet the avoidance path conceals huge pits I've watched investors fall into throughout my 50 years managing money.
Estate planning is wonderful, but too often, sensible planning leads to tax considerations dictating investment decisions. This raises risk, reduces returns and can hit your planned inheritance much harder than any tax rise.
Consider popular ways people now seek to shield pensions from inheritance tax: investing in Aim shares is one, with the double benefit of stamp duty exemption and business property relief. Enterprise Investing Schemes (EIS) are another, and business property relief schemes letting you access unlisted companies is a third.
All these sprang from past governments' investment incentives, hoping to spur entrepreneurship and startups. A fine aim. But pursuing a strategy aimed at these incentives solely for tax benefits aren't the sunlit uplands some promise.
You don't need me to tell you Aim has a long history of scandals and failures alongside those select success stories that graduated to the main market.
Or that its stocks are Britain's tiniest, with a median market capitalisation of £15m. Or that FTSE's Aim All Share is down nearly -30pc since 2000, while the FTSE All Share has soared over 275pc.
Astronomical missed returns are a dear price to pay for tax relief, particularly one whose relief is rapidly diminishing – Aim stocks' BPR relief drops from 100pc to 50pc next year.
EIS and BPR schemes carry another risk: overloading on unlisted companies. These sport the veneer of stability and, in EIS's case, supposedly high growth potential.
They are billed as a way for normal folks to invest in venture capital and reap big rewards when a startup hits it big, but the reality is those are needles in a haystack of hard-to-value, illiquid investments.
Winners aren't guaranteed – untraded doesn't mean stable. It just means fewer pricing points, hiding the inherent behind-the-scenes volatility. That is illiquidity – a bug, not a feature. You risk being unable to sell when you really need to without suffering a steep discount.
Aim companies aren't categorically horrid. Some are fine, even great. EIS and BPR can also be fine tools, in certain situations. But it all depends on your broader goals and time horizon, which gets us to the root of the problem. Your fixation on tax steers you away from why you invested in the first place.
Done right, long-term investing is about picking the correct asset allocation – the blend of stocks, bonds and other securities – for reaching your goals over your investment time horizon.
Your goals are the primary purpose for your money, usually growth, cash flow or some combination of the two. Your time horizon is how long your money must last, usually your lifetime – clearly longer if inheritance tax is a concern.
Throughout history, stocks and bonds have done a marvellous job of delivering the growth and cash flow people need, given a sufficiently long-term horizon and reasonable withdrawals.
Stocks deliver abundant long-term growth, despite bear markets and volatility along the way, while bonds cushion expected short-term volatility and support cash flow with interest. British and global listed stocks and bonds are liquid – easy to sell in a pinch to cover expenses both expected and sudden.
When tax avoidance takes supremacy, will you let it steer you from whichever liquid asset allocation aligned with your goals and needs? If your pension is loaded with Aim shares, EIS or BPR schemes to reduce inheritance tax, it risks not delivering the returns needed to support your cash flow later on. Aged poverty is a real pain.
Or maybe your pension ends up worth vastly less for your heirs, after tax, than if you had opted for a simple blend of stocks and bonds. If you have a sudden expense, your pension may not be liquid enough to cover it. Then what do you do? Borrow?
Don't forget, tax policy is a whack-a-mole game. Pensions were exempt from inheritance tax until they weren't. After halving Aim relief in 2024's Budget, Labour capped BPR last year.
Some ministers floated scrapping Aim relief altogether. What then? If you focus on tax optimisation, you may find yourself needing to make big changes again. And again. And again. Changes cost money. Taxes are certain in general, but the specifics are shape-shifting.
When your goals and time horizon determine your strategy, there are fewer moving parts. You can build a diversified strategy with a long history of delivering what you need, while taking sensible steps to reduce tax exposure where available.
Tax avoidance is nice. Liquidity, predictability and reaching your goals? Nicer.
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