With just under two months to go until the end of the tax year, investors should be thinking about how to make the most out of their long-term savings. Not sure where to start? Don’t worry, we’ve done the hard work for you.
1. Use your ISA and pension annual allowances
ISAs and pensions are a great way to save for the future because any income and capital gains made on investments held in both products are free from income tax and capital gains tax.
All adults can save a total of £20,000 each year to the various types of ISA available. The Lifetime ISA has its own maximum of £4,000 that sits within the total allowance. You can only pay into one ISA of each type (Cash, Stocks & Shares, Lifetime ISA) during a tax year. Importantly, if you don’t use all the allowance, it can’t be carried forward, so you lose it for good. Investors with unused ISA allowance for this year should consider using it if they can before the 5 April deadline. If you use up your annual ISA allowance, you won't be able to pay back money you've previously taken out.
The pension annual allowance for 2020/21 is £40,000 - this includes both contributions made by you and your employer. The annual allowance can be carried forward for up to three years, so investors should consider whether they have made as much use of their pension annual allowance as possible ahead of the end of the tax year. If investors are planning on carrying forward their annual allowance, it’s worth remembering that they must have been a member of a registered pension scheme in the tax year concerned to benefit.
Those with very high incomes or those who have started to take taxable income from drawdown will have a restricted annual allowance.
If you are looking to make use of carry forward, note that personal contributions in any year are also limited for tax relief to 100% of your earnings. People with no earnings (including children) can still save up to £3,600 a year in a pension (including basic rate tax relief).
2. Ensure you benefit from free Government cash
A significant benefit of pensions and Lifetime ISAs is that money you pay into them will benefit from a top up from the Government.
This is most generous in pensions, where personal contributions are automatically topped up by 20% pension tax relief from the Government. That means that every 80p you pay into your pension is automatically topped up to £1. Higher rate and additional rate tax payers can reclaim an additional 20% or 25% tax relief respectively via their tax return. So, for a higher rate tax payer, every £1 that ends up in their pension only costs them 60p. Even with just basic rate tax relief, if you contribute £100 a month to a pension and assume 5% investment growth each year, the Government contribution to your pension would be worth £38,000 after 40 years of saving.*
With the Lifetime ISA you can get up to £1,000 a year in the form of a Government bonus, up until the age of 50. If you opened a Lifetime ISA at age 18, that is a maximum Government bonus of £33,000 (or £32,000 if you’re unlucky enough to have your birthday on 6 April). The Lifetime ISA can be opened by those aged 18 up to the day before your 40th birthday, and you can save up to £4,000 each year – either in one or more lump sums or as a regular monthly saving. You can withdraw Lifetime ISA money once you’ve reached age 60 or earlier to buy your first property, but be warned that if you take the money for any other reason (apart from severe ill health) you’ll pay an exit penalty which is currently 20% but is due to increase to 25% on 5 April.
3. Consolidate old pensions
Many people will have jobs with multiple employers throughout their career and can therefore end up with multiple pension pots with different providers. If you are in this position, there are benefits to be gained by consolidating them into one place with one pension provider.
Firstly, it should make it much easier to manage your pension savings. Having one portfolio to manage means you can ensure your investments are well diversified, without any overlap and more easily track the performance of your portfolio and whether you are saving enough to meet your retirement income needs.
High charges can have a devastating impact on the value of your fund over the long term. Consolidating all your pots with a single, good value provider that meets your needs means you can ensure you are getting value for money and not overpaying.
This applies mainly to defined contribution pensions where you may have multiple pots of pension savings in different places. Defined benefit schemes that pay out a guaranteed income are different and financial advice must be sought before considering transferring them to a different scheme.
4. Work out which ISA is right for you
ISAs are a simple savings product but there are a number of versions, which cater for different needs.
If you are saving for a house deposit, the Lifetime ISA is worth considering because it benefits from a 25% Government bonus on up to £4,000 that can be paid in each year and a withdrawal for a first-time house purchase incurs no penalty. So that is up to £1,000 bonus each year and a Lifetime ISA can be held in cash or invested in stocks and shares.
If you are saving over the short term for something other than a house deposit, say within the next five years, then a Cash ISA could be the solution. However, with interest rates at historic lows, cash savings are likely to be eroded by inflation over the longer term.
Over the longer term, it is worth considering a stocks and shares ISA which offers access to a broad range of funds and shares, with the possibility of higher returns. If you assume investments return of 4.5%** a year after charges, a £20,000 ISA pot would have grown to £31,059 after 10 years. Over the same period, a £20,000 investment in a Cash ISA earning the average interest rate of 0.35%*** would have turned into just £20,711. After 20 years the difference between the two pots would be £26,787.
5. Don’t forget Bed and ISA
If you have investments held outside an ISA wrapper a Bed and ISA transaction is a simple way to open and fund a new ISA or top up an existing one. The investment outside of the ISA is sold, the proceeds moved into an ISA and used immediately to purchase the same investment within the ISA. Depending on which investment platform you use, the two transactions that make up a Bed and ISA may be counted as just one deal so you will only be charged one dealing charge.
Bed and ISA can be useful if you want to take advantage of the tax benefits in your ISA but don’t have readily available cash to invest and you do have investments held outside your ISA that you want to keep.
There may be a capital gains tax liability if the profit on the sale of the investment outside of the ISA exceed your annual CGT allowance of £12,300 in 2020/21 but once in the ISA all dividends and future capital growth are free from income or capital gains tax.
6. Don’t be put off by covid-19 and invest regularly
Whilst it is understandable that people are worried about the uncertainty that covid-19 is creating in the world and for stock markets, it is important to remember that after you pay into an ISA you don’t have to make an immediate investment decision. The annual ISA allowance is a use it or lose it tax break, you can’t roll it over to other years like you can with the pension annual allowance.
So if you have money you want to invest for the long term, make sure you get it into your ISA account before 6 April. Whilst you shouldn’t leave it in cash within a stocks and shares ISA for too long, you can pause whilst you make your investment decisions and you haven’t lost your annual ISA allowance which can be very valuable over the long term.
An option to consider if you are worried about the short-term picture is to feed money into the markets at regular intervals, say monthly. You can set this up to happen automatically on most investment platforms and it should help smooth out any short-term volatility. If stock prices fall, you are investing at that lower price and could benefit even more over the long term if prices rise.
7. Consider if your money is working hard enough for you
Over three quarters (76%)**** of money subscribed to ISAs is cash. The average interest rate on Cash ISAs according to the Bank of England is 0.35%***, which is below the Government’s preferred measure of CPIH inflation of 0.8%, so at that level the purchasing power of your savings is going backwards. This may be OK if the money is to meet short-term spending needs or is your emergency pot and hence you want a low-risk investment. But if you’re willing to dip your toe into the investment markets you could make your money work harder over the long term.
If you invest £250 a month into a Cash ISA paying the average interest rate, after 20 years you would have a tax-free savings pot of just over £62,000. However, the same amount invested into a Stocks and Shares ISA with an annual investment return of 4.5% after charges would be worth just over £98,000.
8. Put your dividend income investments in an ISA
Dividend income from investments held outside of an ISA or pension wrapper might be taxed.
You do not pay tax on any dividend income that falls within your Personal Allowance (the amount of income you can earn each year without paying tax). You also get a dividend allowance each year of £2,000. Any dividend income you get above this amount is taxed at 7.5% for a basic-rate taxpayer, 32.5% for a higher-rate taxpayer or 38.1% for additional-rate taxpayers.
An investment pot of £100,000 that is yielding around 4% as dividends would incur £150 a year in income tax outside an ISA if you are already a basic-rate taxpayer, £650 a year if you are a higher-rate taxpayer and £762 a year if you are an additional rate payer.
9. Set up automatic dividend reinvestment
Any dividends from investments in your ISA can be withdrawn tax-free, but if you don’t need the income now you could use them to turbo-charge your returns. If you reinvest them you can buy more shares in the same investment, which can have a dramatic impact on the size of your ISA fund over the long term.
This is because when you buy more shares each time you receive a dividend, you then receive more dividends next time there is a payout, which can then be reinvested again and so on. Some investment platforms allow you to set this up to happen automatically.
Let’s assume someone invests the full ISA allowance of £20,000 and we assume a compound annual growth rate of 4.5% and annual dividend yield of 3.5% a year. The initial £20,000 will be worth £48,234 after 20 years. £21,960 would also have been banked in cash dividends, to give a total return of £70,194. However, an investor who reinvests the dividends rather than banking them would have £93,219 – more than £23,000 extra. The figures become even more attractive over longer periods:
|4.5% compound annual capital return only||Dividends paid in cash (3.5% yield)||Investment value + cash dividends||4.5% compound annual capital return PLUS 3.5% dividend yield reinvested|
|After 10 years||£31,059||£8,602||£39,661||£43,178|
|After 20 years||£48,234||£21,960||£70,194||£93,219|
|After 30 years||£74,906||£42,705||£117,611||£201,253|
Source: AJ Bell
10. Use your annual Capital Gains tax-free allowance
For investments held outside an ISA or pension, the annual Capital Gains tax-free allowance is very valuable. Investors can make investment gains of up to £12,300 in 2020/21 without paying any tax. Gains over that amount are added to income and if they fall in the basic rate tax band are taxed at 10% and if they fall in the higher rate tax band are taxed at 20%. An additional 8% is added to the tax rate if the gains are from a second property.
The annual Capital Gains tax-free allowance cannot be carried forward into future years so if you don’t use it, you lose it. If you have investments with gains outside of an ISA or pension you should consider whether to realise some of that gain before the end the tax year to make the most of your tax-free allowance. You can also transfer investments to your spouse, in order to use their annual CGT allowance.
11. Get your tax-free personal allowance back
The tax-free personal allowance for most people is currently £12,500. When your taxable income reaches £100,000, your personal allowance is cut by £1 for every £2 of your income, which means you lose it completely once your income reaches £125,000.
For example, someone who gets a payrise from £100,000 to £110,000 will lose £5,000 of their personal allowance. They will be taxed at 40% on their payrise, amounting to £4,000, and then taxed at 40% on their lost personal allowance, amounting to £2,000. This means they pay £6,000 on the £10,000 pay rise – an effective tax rate of 60%.
If you are in this position you could consider reducing your taxable income so that it falls below the £100,000 level where the personal allowance starts to be eroded. You can do this by making charity donations or contributing to a pension. By contributing to a pension you are a making tax savings in the form of getting your personal allowance back whilst also saving for your future and benefiting from pension tax relief at 40%, so you wipe out the 60% effective tax rate completely.
12. Ensure you continue to receive child benefit
All parents are entitled to child benefit, but as soon as one of them earns more than £50,000 they will see the amount they get whittled away, before the benefit is completely wiped out when they earn £60,000 or more.
A parent with two children will get £1,820. a year in child benefit, but for every £1,000 they earn over £50,000 they will lose 10% of their child benefit – so someone earning £51,000 will lose £182.
However, parents who haven’t tipped too far over the threshold can get around this by increasing their pension contributions. What’s counted for the purposes of the child benefit ‘High Income Charge’ is your salary after any pension deductions. This means if you contribute enough to your pension to get your salary back to £49,999 then you’ll get the full child benefit again. Another option is to make charitable donations from the income over the £50,000 limit, which you’ll need to declare to HMRC on your tax return.
However, the frustrating factor for many parents is that the rule applies if one parent is earning more than £50,000, regardless of their partner’s income. So, you could have both parents earning £48,000 each and have no problem, but if one earns nothing and the other earns £60,000 then you’ll lose the benefit. While there are ways around the charge, ultimately some people will struggle to contribute enough to their pension to bring their income down below the £50,000 limit.
13. Start saving for your children
Like adults, children also have tax allowances that can be used each year. The Junior ISA allowance is now a very generous £9,000 a year which enables you to start building a very healthy fund to help them transition into their adult lives. They won’t be able to access the money until they are 18, at which point it automatically turns into a normal ISA and transfers into their name, giving them full access. If you contribute the maximum £9,000 each year and achieved a 4.5% investment return after charges each year, the pot would be worth just over £252,000 by the time your child turns 18. If they don’t touch the fund and don’t pay any more into it, the pot would be worth £1m by the time they turn 50.
You can also pay up to £2,880 into a Junior SIPP each year, with Government tax relief automatically boosting that to £3,600. Your child won’t be able to access the money until they are at least age 57, maybe later if the Government increases the age limit. This ensures there is plenty of time for them to benefit from compound investment returns. If you paid in the maximum each year until your child turns 18 and then they don’t contribute anything else, assuming 4.5% investment returns each year after charges, the pot would be worth just under £562,000 by the time they turn 57 or just over £835,000 by the time they hit the current state pension age of 66.
14. Consider lifetime gifts
Gifting money in your lifetime needs careful consideration to avoid any surprise tax bills. Lifetime cash gifts are known as PETs or potentially exempt transfers and can create an inheritance tax charge if you, as the donor, pass away within seven years of the date of the gift. However, you also have an annual gift allowance of £3,000 and any unused allowance from the previous tax year can be carried forward. Gifts of up to £250 made to an individual are also exempt each tax year. You can also make regular gifts of any size out of surplus income without paying tax, provided your lifestyle is not affected.
*Pension tax relief rates quoted apply in England, Wales and Northern Ireland, different rates apply in Scotland
**The 4.5% per annum investment growth used in this article is based on the inflation adjusted return from equities over the past 50 years of 5.3% taken from the 2020 Barclays Equity Gilt Study and taking off 0.8% for charges
***Source: Bank of England
****Source: HMRC ISA statistics
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