How to shield a financial windfall from the taxman

Whether you’ve downsized and released a lump sum of equity, received an inheritance, or struck lucky with the lottery, a cash windfall leaves you with the kind of dilemma you really shouldn’t complain about.

And this dilemma isn’t solely reserved for older generations. Just a few weeks ago, 16-year-old Luke Littler (pictured) scooped a mammoth £200,000 for finishing runner-up in the World Darts Championship.

Either way, it’s a rare luxury for most people, and that in itself increases the pressure to use the money wisely or invest it tax-efficiently.

Irritatingly, there is no one-size-fits-all “right” answer in these circumstances.

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Shelley McCarthy, managing director of financial planning firm Informed Choice, says there are a number of key questions you should ask: “What are your goals with the money? What do you want to achieve - do you want to retire, or help your children, for instance? How long can you afford to tie up the money for? What level of risk do you need to take? Do you have debt to repay?”

Before you make any decisions with your newfound wealth, it’s useful to have a grasp of the various options, so here are some considerations.

1) Cash won’t cut the mustard

A five or six-figure deposit in a high interest savings account can undoubtedly produce a useful supplementary income stream, and if you know you’ll be spending some of the money in the coming year or two it’s the sensible choice.

For example, if you’ve moved home and will need a chunk of your capital to renovate the new property, it needs to be easily accessible during that time. But as a long-term repository, deposit accounts are typically not a good idea, because interest rates don’t tend to keep pace with inflation so your money might lose value.

2) Plump up your pension

If you’re under 75 (the age at which pension contributions stop receiving tax relief), the most tax-efficient thing you can do with your money is to put it into your pension, because of the full tax relief given on all contributions.

If you’re still working, in most cases you can contribute the lower of £60,000 or 100% of earnings each tax year. Importantly, as McCarthy explains: “It doesn’t matter where the money comes from to make the contribution, but you have to have sufficient earned income to justify it.”

For example: “If you are employed and earn £50,000, the maximum net contribution you can make is £40,000.” The government then tops up your £40,000 with a further £10,000. Higher-rate and additional-rate taxpayers can reclaim a further 20% or 25%, respectively through their tax return.

Importantly, you can also “carry forward” any unused allowance from the last three tax years if you have used up the current tax year’s allowance (and provided you’ve earned enough in the current year to justify the contribution).

The annual allowance rose from £40,000 to £60,000 for the 2023-24 tax year, which means that – in the unlikely event you’ve made no pension contributions from earnings over the last four years – you could put a total of £180,000 including tax relief, into your pension; provided you have earnings to support it.

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However, there are limitations to the extent to which you can stuff your pension. The pension allowance is capped for very high earners. “If you earn over £200,000, your contribution may be limited by taper relief,” says McCarthy.

There are also limits at the other end of the scale. For tax years when you have not earned any income, you can only put in £2,880 (which will be topped up to £3,600 by the government).

In addition, if you’ve already started to take a flexible income from your pensions (your tax-free lump sum doesn’t count here), the so-called money purchase annual allowance kicks in and your annual contribution allowance reduces to £10,000.

All in all, though, pension contributions are a valuable option for anyone who’s eligible, especially as pensions fall outside your estate for inheritance tax (IHT) purposes. “The main drawback is that you cannot access your account until age 55 (rising to 57 in 2028), so this would not be a suitable home for money that is needed prior to that age,” McCarthy adds. 

3) ISAs for flexibility

Individual savings accounts (ISA) also provide a tax-efficient environment for your money to grow in, but rather than receiving tax relief at the start of the investment, investors can make ad hoc withdrawals or take a regular income free of tax; and there are no age restrictions on access. So windfall money in an ISA is much more flexible - and can be a useful tax-free income supplement if needed.

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Everyone has a £20,000 annual allowance, but it cannot be carried over to the following tax year. However, as the end of the 2023-24 tax year hovers on the horizon, there’s the opportunity for a married couple to tuck away up to £80,000 of their windfall using their allowances for both the current tax year and the next, which starts on 6 April.

4) Other investments

Once you’ve used the available ISA and pension allowances, you could turn to other options, such as a general investment account (GIA). Onshore and offshore investment bonds and venture capital trusts (VCTs) are a further consideration, but given their complex nature it might be worth taking some advice.

5) Bricks and mortar

Buy-to-let properties used to be very popular with private investors keen to put their money into tangible assets, but they have widely fallen out of favour since the tax rules were changed to make them much less attractive. The rules have been tightening since 2017, when mortgage tax relief changes were implemented.

“It is less tax-efficient, as there is a 3% stamp duty surcharge on purchase, and higher rates of capital gains tax on property (except for your main home) compared with other assets,” says McCarthy. “There are also maintenance costs, the risk of bad tenants, void periods and the general ‘hassle factor’.”

If you’re tempted by a holiday property for your own use, be aware that many of the same tax considerations apply; and do ensure that you will be able to afford the ongoing maintenance costs as well as the initial outlay on the property itself.

6) Gifting your windfall

There are compelling arguments in favour of passing money to younger members of your family sooner rather than later, but it’s crucial to be sure that you will have enough for your own needs.

Why consider giving away some or all your windfall? If you can afford to make the gift, a lump sum at a relatively early stage of your adult children’s or even grandchildren’s life could make a really big difference to their financial situation, and this way you’ll get to see them enjoy the benefit.

For example, it could provide the deposit they need to get out of rental accommodation and on to the housing ladder, help them clear a chunk of mortgage and reduce their monthly bills, or help with their kids’ school bills.

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From an IHT perspective, if you survive seven years after making the gift, it will fall outside your estate altogether; clearly, the younger you are, the more likely you are to manage that.

“If you are not ready to make gifts to individuals (for example, because you’re not sure they’ll use it wisely at this age), you could make an investment within a trust structure, giving you some control over the investment but starting the seven-year clock ticking,” suggests McCarthy.

“There are also special trust products - loan trusts and discounted gift trusts – that allow you to maintain access to the capital, which again could be suitable depending on your circumstances.”

A windfall is a wonderful opportunity to set yourself and your loved ones up financially – but it is important that you’re able to make informed decisions within the context of your wider financial situation.