If you are finding that you have excess cash within your monthly budget, there is value in saving this money for your longer term future. In this article I have considered two tax efficient “wrappers” that, depending on your circumstances, could significantly enhance any savings you able to make by virtue of tax relief. Before deciding on the tax “wrapper” it would be worth considering a few other steps first.
You should initially consider:
- Paying down debts, especially expensive debt like credit cards.
- Ensure that you have a suitable emergency fund and cash reserve (please see other blogs in this area).
- What level of access you will need to the money you are saving? Can it be left untouched for 5 years or maybe longer?
- Are you comfortable with risking any of the money you are saving?
After you have considered the above, you can then start to formulate your long term plan and essential element of which will be which tax “wrapper” to use?
If you have a medium to long term time frame an asset back investment in something like a stocks and shares ISA, a Lifetime ISA or Pension could certainly have an advantage. In this piece I have concentrated on just the LISA and Pension options. With a wide range of options available to you, the most suitable solution will be informed by your individual circumstances and not simply by the tax efficiency of the wrapper.
Here are some highlights of the two tax wrappers:
Lifetime ISA (LISA)
You are only able to open a LISA if you are aged between 18 and 40 and once you open a LISA, you can contribute each year until age 50. You are only able contribute £4,000 per tax year to a LISA. The government will add a 25% bonus on top of the money you have saved (£4,000 x 25% = £1,000). So, for every £4,000 you save you end up with £5,000 invested. Any growth or income within the LISA will be free from income tax and capital gains tax.
You can access your LISA at any point, however if you do this before the age of 60 or you do not use the investment to purchase your first property, you will be penalised and lose 25% of your investment (you are not penalised if the withdrawal is made because you are terminally ill, with less than 12 months to live). The £4,000 contribution counts towards your overall annual ISA allowance of £20,000.
Most UK residents can open and contribute to a pension. You will start with an annual allowance of £40,000 per year (although this will be reduced if you are a high earner, see tapering within other Wingate articles) and you can potentially carry forward unused allowances from the previous three years, if you have qualifying earnings. Any growth or income related to your pension will grow free of income tax and capital gains tax. Importantly for most pensions, the money within the pension will sit in trust outside of your estate for inheritance tax purposes.
If you are employed, there is the added advantage that your employer may match your contributions into a pension, to a certain limit. This can have a marked impact on the benefit of each contribution.
You cannot access your pension until the age of 55, under current legislation. When you access your pension, you will be able to draw 25% as tax free cash however the remaining capital will normally be taxed at your highest marginal rate, even if you are retired.
Below I have made a simple comparison for a £4,000 contribution into each “wrapper”.
I have ignored growth and assumed that a higher rate taxpayer whilst working, will be a basic rate taxpayer in retirement. This can be the case, but care should be taken not to take this summery and apply it to your own situation.
||Pension (basic rate taxpayer)
(higher rate taxpayer)
|Values at withdrawal*
|Tax to be paid assuming BRT** in retirement
|Total take home figure
*please note the age at which you can access funds are different depending on the wrapper.
**basic rate taxpayer
It is interesting to note that, within this simple example: If you are a higher rate taxpayer, you could still be in a better position contributing to a pension, given the tax relief you receive on this contribution. However, the difference is only £100 and importantly a LISA could compliment your pension and add significant value to your long term plan. You can always do both!
If you are a basic rate or higher rate taxpayer with access to an employer’s pension where they will match your contribution, this could be in all likeliness the most efficient location to make contributions. This is due to the employer effectively doubling your money when matching your contribution.
However, if you have maximised your matched employers’ contributions into your pension, or you do not have access to an employer’s pension, it is a much closer comparison. I would go as far to say that for a basic rate taxpayer, a LISA could be more advantageous.
The above is a summary of a simplified scenario. It is important that you take these tax advantages and weigh them against a wide range of other factors.
Part of the process that we guide our clients through at Wingate is to consider their full financial position, as well as their long term objectives to make the most suitable recommendation tailored to their needs. The simple tax implications of a suitable “wrapper” will not be the only driver behind building a long term plan, the old adage of “not letting the tax tail wag the dog” comes to mind.
If you would like to have a wider discussion regarding your plans for the future or if you do not have a plan and would like to start one, please feel free to contact us.