Now this could be an article about fizzy drink, chocolate or any other thing – and you could be wondering what on earth would prompt me to write about such things – but hang in there, this does have a financial relevance.
The purpose of a wrapper is to hold the contents inside, and to offer some sort of protection from the outside world – and the same is the case when we’re talking about investments – in which case we are talking about protecting assets from TAX.
We all pay tax in some way directly (income tax, capital gains tax, inheritance tax) or indirectly (VAT)…. But no-one really wants to pay more than legally and ethically necessary, so it is often necessary to consider ways to protect your hard-earned money from being eroded more than it must.
If you have money to tuck away each month for the longer term, you may at some point need to choose between two main product ‘wrappers’ – one being a pension and the other being an ISA. The contents can be the same, cash/investment fund etc. but the wrapper is what determines the tax treatment and when the money is available for you to use.
Pensions are a tax-deferred arrangement. You are encouraged to save for retirement by being given tax-relief on your contributions up front – think of this like free money from HMRC. If you are employed, you are likely to be part of your workplace pension scheme – although workers on lower incomes, the self-employed and company directors will need to make their own arrangements for a comfortable retirement.
The tax relief means that for a basic rate tax payer (typically earning less than £45k per year) for every £100 you contribute, HMRC gives you another £25 and a total of £125 goes into your chosen fund.
Higher rate tax payers get more, usually by adjustment of their tax code, or claimed by self-assessment. Your employer will also contribute (more free money) and this money left to grow for 20+ years can lead to a considerable sized pot.
The downside is that you can’t take the money back out until you are 55 or older – don’t believe scams that try to tell you otherwise – and although you usually get 25% of the pot tax free – you pay tax on the rest of the money as you withdraw it, at whatever rate of tax you pay at the time. If you end up with a pot in excess of the lifetime allowance, you may be taxed at a higher rate than you expect.
The hope for most people is that they will drop a tax band in retirement, and so pay less tax on the way out than the free money they were given on the way in. For example, a higher rate worker may become basic rate in retirement, and a basic rate worker may become a non-tax payer if their income falls below the annual allowance.
But in reality, even if you stay on the same tax band you make money, as you’ve benefitted from the compound interest on the free money and you get to take a proportion of the pot tax free.
With new modern, flexible pensions money can be withdrawn as and when needed, whereas older schemes may insist you buy an annuity / guaranteed lifetime income.
ISAs are tax-exempt for both capital gains tax within the funds, and the income when you choose to withdraw it. So if you invest £100, that is all the money that goes in. You have already paid tax on this money (as this has come from your earnings after tax) and so have no further tax to pay when you withdraw the money, no matter how big your fund is.
The annual ISA allowance for this year (2018-19) is £20,000, which in effect allows you to pay into an ISA up to £20,000, but this year’s allowance is lost in April if you haven’t used it.
You can access your money at any point and do not need to wait until you are 55, but as I explained in my earlier article, an investment based ISA should usually be held for 5 years or more so as to allow dips in the market to correct themselves over time.
Ok, so what does that mean for me?
I don’t know. Everyone is different and their circumstances are different.
For many people, they will need a combination of the two, but it will depend on many factors including when they need to access the money, the income they expect in retirement and whether they will get a full state pension.
It may also depend on whether your employer matches your pension contributions – if you pay in more, they may do too…and that’s more free money to take into account.
Either way, planning for retirement can look very different these days – how much money would you like to live on in retirement? When do you want to stop working?
It’s never too late to start planning!