Why you should make use of pensions and ISAs
The easiest way to improve your investment returns is to invest in a tax efficient account like a pension or ISA. These allow you to minimise your tax liabilities so that you get to keep more of the income and capital gains for yourself.
If you are saving for retirement the best option is normally a pension. These entitle you to full tax relief on contributions of up to 100% of your annual earnings or £40,000, whichever is the lower, unless you are a very high earner with income of more than £150,000 per annum.
For employees the most cost-effective option is to join your workplace pension scheme. These tend to offer a fairly limited range of investments to choose from – normally it will just be managed funds, not individual shares – but most employers will make contributions on your behalf.
Every £80 that a basic rate taxpayer contributes to their workplace pension will be increased by £20 tax relief. Your employer will generally top it up even further, with many paying an extra 5% or more. This would mean that a £105 contribution would only actually cost you £80.
Those in the 40% income tax bracket would have to pay even less as they would be entitled to £40 tax relief, so a contribution of £105 would only cost them £60 assuming that their employer paid in 5% on their behalf.
If you are saving for retirement the best option is normally a pension.
If you are self-employed or want more choice over your investments you could open a Self-Invested Personal Pension (SIPP). These normally provide access to a wider range of managed funds as well as individual shares and bonds. A SIPP operates in a similar way to a workplace pension except that you have to claim the higher rate tax relief on your end of year tax return.
Once the money is invested in a pension there is no income tax to pay on the investment income and no Capital Gains Tax on the investment gains. The earliest you can take the benefits is at age 55, rising to 57 from 2028, at which point you can withdraw up to 25% as a tax-free lump sum with all the other withdrawals being taxed as income.
If you are between the ages of 18 and 39 and saving up for the deposit for your first house or for your retirement you could open a Lifetime ISA. These allow you to pay in up to a maximum of £4,000 per tax year with the government topping the annual contributions up by a 25% bonus each year until your fiftieth birthday.
All the gains and income in a Lifetime ISA accrue tax-free, just like in a pension. You can take the money out tax-free and without a government charge to help buy your first home worth up to £450,000 at any time from 12 months after you first save into the account. Otherwise you can wait until you are 60 and use it to provide a tax-free source of retirement income.
The other main option is a Stocks & Shares ISA. You can pay in up to a maximum of £20,000 a year – less whatever you pay into any other type of ISA – and invest it in a wide range of permitted investments. There is no tax to pay on the income or gains and you can take your money out tax-free whenever you want without any government charge, although there is no government bonus or tax relief on the contributions.
It’s a shame Nick Sudbury makes no mention of the highly punitive Pension Lifetime Allowance imposed by the Government and cut heavily in recent Budgets. The Lifetime Allowance states that if your total pension assets – from *all* pensions, not just personal ones – exceed £1 million, you are taxed at 55% on any lump-sum withdrawals or 25% on regular income withdrawals, on top of regular income tax. A £1 million total pension value may sound like a lot, but many people with a SIPP and a few workplace pensions could easily exceed this figure, despite never having been a higher-rate taxpayer in their working lives.
Pension assets are periodically re-assessed too by HMRC, so people using income drawdown from a SIPP could be caught after retirement as well at their official retirement date, even if they take the absolute maximum 25% lump sum out in cash. For example, if someone had no other pensions and a SIPP of £600K invested in growth equities, this might generate a modest income drawdown of £12K p.a. if the total dividend income is 2%. However the total fund value, after five good years with returns averaging 15%, is going to be well over £1 mill, yet still producing only £20K in dividends, and one’s personal marginal rate of tax on any further withdrawals will shoot up.
Occupational pensions are valued at twenty times the annual pension payout, so if you had four funds from different past jobs producing, say, £5K each, that counts as £400K in assets. Add a SIPP of a few £100K on top of that, and it won’t take much to tip you over the £1 million threshold.
The Government claims it aims to increase the Lifetime Allowance by inflation in future, but this can be changed at the flick of a Chancellor’s pen and as arbitrarily as the reductions in the Allowance in recent years. Inflation is also currently much much lower than investment returns, so does little to protect citizens really.
This arbitrary threshold will push people to invest for retirement in ISAs as well as pensions, and force them to keep assessing whether they have “too much” in pension savings, which in a sensible tax system that encouraged saving should never be an issue. People with larger occupational schemes are also going to invest in property as an alternative to pensions, with the aim of giving this away to their descendents well before their likely age of death, or else their estates will be hit by hefty IHT and CGT taxes.
The points you make about the recent reduction in the Pension Lifetime Allowance are perfectly valid and reflect the direction of political travel. There could also be further cuts, especially if Labour get back into government. The only point I would make is that of all the millions of people paying into a pension relatively few will be affected by the cap. For example, according to figures from the government, only 17% of those aged between 55 and 64 have pension assets of more than £500,000. For most people the tax relief means that a pension is the best way to save for their retirement.