Pensions & ISAs – the basics

I was recently asked on the the excellent Monevator website what my thoughts are on pensions and saving for the future. I hope this post can give you a rough guide to how pensions and ISAs work in the UK and give you a rule of thumb about how to start using them to achieve your financial aims! I’ve included ISAs as I think you can’t understand one without the other.

 


 

When I was 16, nobody explained the concept of a pension or an ISA (or income tax, for God’s sake – yet we teach kids about Oxbow Lakes???). The second step in sensible financial planning is understanding these concepts.

Wait! What’s the first step?

Before we start on pensions and ISAs you have to understand your first step. The first step is:

Have a financial and life aim

By that, you need to ask yourself: What do I want to achieve in life? Why do I want to achieve this? Where do I have to get to financially to achieve this?

An example:

John wants to have two children with his wife and have a stable, permanent home for him and his family to live in. He wants this because he wants to give a stable upbringing to his children.

 

Without being Captain Obvious, John’s going to need a lot of money to do this. He’s going to have to save up money to put down a deposit for his house. He also has to be able to access that money. But he might not need to access any savings for a number of years. He will also need to have a stream of income when he and his wife have kids. And he will likely need to have some level of savings for one-off expenses relating to raising his children.

This also helps us address the four key factors in saving and investment. These are:

Risk tolerence, Time-horizon, access and affordability

Risk can be defined in a huge number of ways and the financial services industry has devoted sagas to what risk means. But broadly speaking, what matters is Risk tolerence – what risks are you willing to take to meet you financial aims.

Time-horizon – this is the time you have over which to meet your financial aims. Generally speaking, the longer away you are from your aim, the easier it is for you to swallow risks.

Access – this is whether you may or may not need to access your savings and investments. Generally speaking, the higher the likelihood you will need to dip into your savings pot, the lower your risk tolerence will be (to avoid making potentially large losses).

Affordability – this is whether you can actually afford to make the savings and investments you plan (i.e. what you are able to sacrifice spending today to be able to spend tomorrow). You won’t be able to afford to save everything – so you need to start prioritising how and what to save and invest.

As you can see these four concepts are interlinked.

The Second Step: Pensions and ISAs

Pensions

If you’re faced with your first “real” job, the offer of a pension may seem daunting. In the UK, the vast majority of workers over age 21 will be offered a contributory pension arrangement (where your employer pays into a pot of money which is invested until you retire). These are called Defined Contribution (DC) schemes or in old language, Money Purchase schemes. Generally you have to wait until you’re 55 to take this money – however the Government is currently thinking about increasing this age, and it has done in the past. Until then you can’t get your hands on the money and do what you want with it. At the moment you can take the entire amount in cash thanks to the now famous Pension Flexibilities (that thing the media keeps saying about pensioners spending their money on Lamborghinis). But when you take the money out, you get taxed on it.

The first question for a millennial is then : why wait till age 55? Why not just keep the money I would have otherwise put into a pension and enjoy it now? Because of three things: employer contributions, government reliefs and compound returns.

The first benefit is if your employer contributes to your pension (i.e. you pay in 5% and they match your contributions) then you’re getting free money. Literally free money. If you don’t pay in that 5% you aren’t going to get the money in lieu- it’s a quid pro quo deal. Not paying in means you’re losing out on money from your boss.

The second benefit is that the government effectively gives you back any tax you’ve paid on your salary if you put it into a pension. There are some caps on how much relief you can get, these are (in basic terms, the allowances are very complicated and the exact allowance you may have will depend on a large number of circumstances):

  • The Annual Allowance – which means you only get tax relief on the first £40,000 you put into your pension. This gets reduced down to £10,000 for very high earners by something called the Tapered Annual Allowance (which I won’t expand on for now as it’s painfully complicated).
  • The Lifetime Allowance – which means you only get to keep your relief if, when you come to take money out of your pension, the total of all your pension pots is below £1,030,000 (for 18/19). If you go above this, then HMRC will charge you a hefty penalty tax.

The Government also give another sweetener for those willing to put into a pension, that is when you take out the money you usually get to take 25% of it tax-free!

The third benefit is that as your money is left in a pension for a very long time you start to get “compound returns”. That is, returns on returns. Over 20/30/40/50 years, the compounding effect can become enormous. This is sometimes called a “snowball effect” – as a snowball rolls down a snowy mountain side it picks up more and more snow and gets rapidly bigger. A pension’s biggest weakness – that your money is trapped for a long time – is also its biggest strength. By not being able to touch your money you can’t prevent your snowball from becoming an avalanche.

As a second option, there are Personal Pension Plans (called PPPs) and SIPPs (Self-invested pension plans). These work much like a workplace scheme, except you put money in from your after tax-earnings. HMRC then automatically add 20% to whatever you put in (you have to claim the extra 20% if you are a higher rate tax payer via self-assessment or by application). You then select your investment option from a list of available investments – which are typically much broader than for workplace pensions, particularly so for SIPPs.

But there is a big problem with pensions. That is, because your money is locked in, you are at the mercy of the rules the government comes up with. You would think that, as the government wants people to save, it would try to keep the rules as consistent and as simple as possible. Unfortunately, that is not the case. Politicians have continually meddled with pensions and its clear they will continue to do so. When I speak to people, my general guidance on this is:

Think up your rough retirement date. Say its 20 years away. Between now and then there will be at least 4 governments. Now imagine the worst possible government (for your financial aims) that you could get during that time (or Donald Trump…). If you put your money into a pension, you are completely at the whim of that government. Could you live with that arrangement?

 

Usually this scares people a bit. And at this point it is should be clear pensions can’t be the only answer. That’s where ISAs come in.

 

ISAs

An ISA (Individual Savings Account) can either be a cash ISA (an account which earns interest at a set rate) or a stocks and shares ISA (you put your money into pooled investments linked to the market). You can only invest a certain amount into any ISA/s in one year – capped at £20,000 in 18/19. The earlier you open an ISA the longer you have to build up your snowball. You can also take your money in and out whenever you want subject to the cap – however, most places now offer “Flexi-ISAs” which allow you to take money out and put it back in and not lose part of your allowance. With an ISA you don’t get tax relief on money you put in. But, money you make in an ISA is tax-free – both income and gains. In effect, its like a ghost to HMRC.

HMRC don’t like ghosts and so George Osborne came up with a bastard-child of ISAs and pensions called a Lifetime ISA or a LISA (primarily because the treasury gets to hold on to tax money for longer if you put it in a LISA). You can only put £4,000 a year into a LISA (and that counts as part of the £20,000 above). But the government gives you a generous 25% bonus on the money you put in i.e. for every £100 you put in the government gives you £25. In addition you won’t be taxed when you are able to take money out of a LISA. But the government aren’t (always) in the business of giving out free money. There’s a catch – and it’s a big one. You can’t touch the money until you are either 60 (yes, that’s older than for other pensions) or to buy your first home (and in true government fashion, there is a huge small print on what homes can actually count, so you have to be very careful if this is what you are planning). Strictly speaking you can take your money out of a LISA, but there is a huge penalty for doing so and it would be extremely inadvisable to do so. One final catch is if you are over 40, you can’t open one. Sorry – you’re out of luck.

With all that out of the way, let me present the YoungFIGuy Pension and ISA Super Table! (it’s not that super, don’t get your hopes up). Please note, and I have to say this, I’m not an FCA authorised financial adviser. The table below is a rough guide/rule of thumb for information purposes only and should not be considered financial advice. The table may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.

I have spare money and want to save and invest for my future what do I do? Note: this is rough guide – what is best for you will depend on your exact circumstances – I would always recommend seeking the advice of a personal finance professional
      Pros Cons
1 If you are employed, contribute to your workplace pension up to the amount that maxes the free money from your employer If you are not an employee go to 2 – FREE MONEY

– Generous tax reliefs

– You can’t meddle by taking money out

– Your money will be tied up until at least 55 – check access requirements

– The pension investment options can be expensive

– There are usually limited investment options

2 If you do not own or have never owned your own home and you plan to do so, max out your LISA.

(Subject to the type of home you are buying qualifying for the scheme)

If you own or owned a home, or the home you’d like doesn’t qualify go to 3 – Very Generous tax relief

– You’ll get access to your money before any pension

– Lots of investment options: from low risk to high risk

– Some homes and some situations mean you won’t qualify to withdraw to buy a home, then you can’t withdraw until at least 60 – check access requirements

– You are at risk the government changes the rules on you

– Not as widely available as pensions and ISAs

3 Max out the rest of your ISA allowance   – All income and gains are tax-free

– You can access your money whenever you want (and put it back in with a Flexi-ISA)

– Lots of investment options: from low risk to high risk

– The total tax relief is not as good as for a LISA or a pension

– You are in control, you have to have the discipline to not take money out on a whim

4 If your company offers “salary sacrifice” and they give you any national insurance savings they make by paying money straight into your pension, then contribute as much up to the Annual Allowance (AA) If your employer doesn’t offer salary sacrifice got to 5, if you’ve maxed your AA go to 7 – You get an added bonus from saving NI contributions

– Generous tax reliefs

– You can’t meddle by taking money out

As under 1
5 If the annual costs for investments in the company pension scheme are less than 0.5% then contribute as much up to the Annual Allowance If the costs are above 0.5% you can generally speaking invest for less in a private pension or SIPP – Generous tax reliefs

– You can’t meddle by taking money out

As under 1
6 Invest into a private pension or a SIPP up to the Annual Allowance if you’ve maxed your AA go to 7 – Generous tax reliefs

– You can’t meddle by taking money out

– Lots of investment options: from low risk to high risk

– Your money will be tied up until at least 55 – check access requirements

– The pension investment options can be expensive

7 Well done, you’ve saved a bollock-ton of money! At this point there are a number of tax-efficient and non-tax-efficient options available, you should speak to an Independent Financial Advisor about which ones might work best for you

 

If you have any thoughts, suggestions or questions, please feel free to leave a comment!

All the best,

YFG

Comments

  1. some other benefits of pensions

    1. within the pension wrapper you can move stuff about without worrying about CGT
    2. you can arbitrage higher rate income tax relief today against expected lower rate income tax when you access the pension

    also a SIPP contribution doesn’t have to be after tax – you can salary sacrifice into one from gross pay. This has the benefit of saving on NICs contributions. If you’re lucky, you can get your employer to throw in the employer NICs savings as well..

    1. These all very good points. Thanks Rhino.

      I wrote quite a bit more about SIPPs – but then the post started ballooning, so I thought I’d try to cut back as the post was getting quite long!

      I’ve got an idea for a post about pensions wrappers, CGT and transfers – so watch this space!

  2. I started with cash ISAs, was unsure of a life changing event appearing where I need access to the cash, then as that became clearer how to manage I moved over to maxing out a stock & share isa plus adding to a normal share account. Now I’m making use of salary sacrifice to add more into my dc pension as well keep all my income below the higher tax band rate so my dividend tax rate due is 7.5% instead of 32%.

    Watching yesterdays news reports on the new tax year and increase in auto-enrollment contributions it was sad how negative the media were reporting this. Individuals and they employers are putting too little into their pension, it’s a ticking time bomb that society isn’t making clear, needs a shake up.

    The statement the media gave:-
    “For many, this increase will feel like a harsh jolt.”

    Should really be:-
    “For many, this increase will feel like a light bulb for planning for more in, including employers contributions.”

    http://www.bbc.co.uk/news/business-43654409

    1. Great to hear you are building up your pot reckless.

      I was also so disappointed to see the media reporting on auto-enrolment. This is a great thing for employees and the increase in employee contributions is being ‘matched’ by the employer. Given the rates go up again next year, are we gonna see the same reporting? Not to mention, this has been outlined for a very long time. Most people, if they’ve bothered to even cursory read the information their employers gave to them, would have been well aware of the changes.

  3. I’m doing a similar planning exercise for my son. He’s saving in an Auto-enrolment pension, going to max out LISA then put what he can then into ISA. As I worked out his figures it became apparent that if he put too much into pension he would have the problem of reaching the lifetime limit and the gap between FI and when he could draw a pension was too great. I’m in the middle of a blog post detailing this up.

    1. Hi Fu Mon Chu – thanks for the comment. It is very difficult for people even 10+ years away to know if they might breach the LTA let alone 20/30/40 years. The government has belatedly nudged up the LTA for this tax year by a whopping £30,000 but unfortunately have made no commitment to continue doing so (see my latest post ). It’s very difficult to know what level the LTA might be long into the future, or if it will even exist!

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