VALUE INVESTING
The Value Vehicle

By Stephen Bland (TMFPyad)
June 23, 2005

Whether you prefer to trade value shares short term, invest in a high-yield portfolio for the very long term, or perhaps both as offered in Value Investor, the question arises as to how you should hold your shares.

There are three main ways to hold shares : direct, inside an Individual Savings Account (ISA) or a Self-Invested Personal Pension (SIPP). These are not mutually exclusive, so any or all of them can be used.

The differences between these three arise from the various tax treatments and the consequent restrictions and impositions imposed as a result. Direct holding means that income and capital gains are subject to taxation to the extent that the holder may be so liable. However, there is no restriction on what can be done in terms of the amounts invested, no special charges, and full freedom of access to your money. Both the ISA and SIPP schemes offer tax avoidance, though in very different ways.

Taking direct holding first, note that the tax exposure frequently may not be as bad as it might sound, depending on personal circumstances. Looking at income, share dividends are tax free to basic-rate taxpayers, and higher-rate taxpayers suffer 25% income tax, which compares very favourably with the 20% and 40% tax charged on interest income. There is an annual exemption for capital gains, £8,500 at present, before CGT applies, but note that this is not cumulative. The allowance is given each year against the net realised gains in that year and cannot be carried forward.

Maxi-ISAs are the only kind worth considering for serious share investors (which I presume applies to all Value Investor readers), as they are simple and straightforward, sheltering both dividend income and gains on shares. In consequence, they are particularly useful for higher-rate taxpayers, because they avoid income tax on dividends and, if anyone is fortunate enough to realise over £8,500 in net gains in a year, then this too will be free of tax. Very importantly in my opinion, ISAs offer instant access to your money almost as freely as if the shares were held directly. There is no requirement to tie up your funds.

The only real downside is that there will be a charge but, often, this is small. One well-known broker charges £25 a year, for example. The other limitation is the £7,000 per tax year that can be placed into the ISA, which is not much use for someone with a large lump sum setting up a high-yield portfolio (HYP). That aside, ISAs could be used effectively for either a value trading or an HYP strategy, particularly where the latter is being created by instalments, as I know many readers do.

Compared with the relative freedom of ISAs, SIPPs are a very different matter. They are really just personal pension schemes, with all the onerous restrictions of the genre. The principal difference is that you choose the investments and, thus, they can be used for a value trading or HYP strategy. Of all the restrictions that SIPPs impose, which include much higher charges than ISAs (though larger amounts can be invested), the most serious is the complete inability to access your funds at will.

Once money is contributed to a SIPP, it is tied up until the earliest pensionable age. Ultimately, three-quarters of it will have to be used to buy an annuity or other forcible income arrangement. In return for what I regard as this very serious impairment, tax relief is given on contributions at the investor's highest rate, subject to certain limits. The eventual income is taxed, thus negating a large proportion of the original tax relief, though a quarter of the fund can be taken as a tax-free lump sum.

So, what to do? For a higher-rate taxpayer, there is little reason not to use an ISA up to the maximum annual investment limit of £7,000, whether for value trading or HYP. The charges are low, and the unfettered access makes this a highly desirable option - even if only to protect dividends from tax, which is particularly attractive for long-term HYP shares. For a basic-rate taxpayer not expecting to make annual gains over £8,500 and not expecting to become a higher-rate taxpayer in the future, an ISA may still be desirable. It may be particularly useful for a long-term HYP under construction, where, eventually, substantial gains may be made at some distant point. However, this is not such a compelling argument.

Generally speaking, I am against SIPPs, whatever the tax rates. I know the attractions of 40% tax relief on what could be substantial contributions are pretty powerful, but I still don't like them. I am always against compulsion, and SIPPs deliver compulsion in spades. The idea that you can never simply get all your money back, but will be compelled to take some sort of taxable income on most of it, and from a captive market too, fills me with fiscal horror. Personally, I don't think value investors should, in consequence, consider SIPPs.

As a value investor writing Value Investor, I'd advise people to pay more tax now and have the total freedom to invest their money as they wish for the whole of their lives, through direct and ISA approaches, rather than lock themselves into a SIPP.

The identities of Stephen Bland's favourite shares can be found only within Value Investor. You can  enjoy a free trial of the newsletter here.