New world order of saving
Pensions freedom and choice has radically changed the face of saving. No longer are pensions just a means of providing a regular stream of retirement income – they can be used to fund any life event after the age of 55.
Unlocking the full potential of the new savings landscape requires a fundamental change to existing savings habits.
So what might you need to be doing differently with your life savings?
- Spendable and inheritable wealth can be increased, at no extra cost, by simply taking full advantage of the new flexibility and saving into the right tax wrappers at the right times.
- Save with the end in mind – make full use of reliefs when saving and maximise allowances when accessing funds to achieve the greatest net spendable income.
- Access to funds may be a key consideration for younger individuals, but for the over 55s it’s now a level playing field.
- Take steps to move savings between tax wrappers when the time is right – this may start as early as late 40’s when the opportunity for tax relief may be at its peak.
These factors will influence the order in which you save for their retirement and the order which you access your funds to provide an income. For saving, this will typically be:
- Offshore Bonds/OEICs
And in reverse order when accessing funds, so that pensions funds are preserved for longest.
Where to save
Your aims and objectives are always paramount when choosing the right home for your savings. There’s no point saving for a deposit for a first home if you can’t get the keys to the door until 55.
Access to funds may be a key consideration to younger individuals, but the closer you get to 55 the less bearing this has on the choice of investment wrapper. Unrestricted access to pensions for the over 55s shifts the balance of power in the savings war.
Savings priorities inevitably change over time and saving habits need to move with them. And that could mean moving savings between tax wrappers when the time is right.
Where everything else is equal (e.g. investment funds, charges etc) choosing the best place to save is a numbers game. The goal is to identify the tax wrapper which will secure the best return after all taxes have been deducted. This typically means seeking out tax privileged investments which will deliver gross investment returns ahead of taxable investments.
- Pensions – the ins and outs – the combination of tax relief on contributions coupled with the ability to take a quarter of the fund tax free make pensions very hard to beat. It has long been recognised that pensions are the most tax efficient way of saving. What has changed is that they’re now far more accessible than ever before and now allow greater opportunity to provide a legacy from any funds which are not spent during retirement. And this should increase their appeal to savers as age old barriers to pension savings, such as limited access and loss of fund on death, have been removed.Ins – for Defined Contribution (DC) schemes, you will normally pay in an amount net of basic rate tax, with the provider adding basic rate tax to the fund. Any higher or additional relief is claimed through self-assessment.So a £10,000 pension contribution will require a payment of £8,000. If you are a higher rate tax payer , you would be able to claim a further £2,000 tax relief via your tax return and this will reduce the tax you pay on any other income. So the net cost to you paying higher rate tax is £6,000.Outs – up to 25% of the pension fund can be taken completely tax free. The balance is taxed at your highest marginal rate of income tax.
That means the £10,000 contribution in the example above, ignoring growth and charges etc, would provide £3,000 tax free cash and £9,000 of taxable income. For a higher rate taxpayer that would be £8,400 in the pocket (£3,000 tax free cash and £5,400 net income) or, if income in retirement means they’re just a basic rate taxpayer, £10,200 after tax (£3,000 plus £7,200). That’s a significant uplift on the net cost of £6,000.
Once you are over 55, you have just the same access to your pension as you do to your bank account or ISA. It takes a huge shift in mindset to move that emergency or rainy day fund from your High Street bank and put it into your pension, as the myth still exists that the pension is locked away and can’t be touched.
- ISAs – like a pension, an ISA pays no additional tax on income and gains within the fund. They are very simple and easy to understand; there’s no tax relief on the way in and no tax to pay when money is withdrawn.Why ISAs sit behind pensions in the retirement savings order is due to the fact that pensions will, like for like, outperform ISAs in the majority of client scenarios. This is down to the combination of tax relief on contributions and the ability to take a quarter of the fund tax free.The only situations where the ISA will have the upper hand are where someone receives tax relief at a rate lower than the rate of tax payable when they take their income. Typically someone getting only 20% relief on their contributions but, by accessing their pension in one go, ends up paying tax at 40% (or more) on a large slice of their pension fund.Anyone who has sufficient allowances and will receive tax relief at 40% on pension contributions will always be in a better position saving in a pension, regardless of how much tax they pay on the way out. And a strategy of moving existing savings into the pension in the run up to retirement would boost what you might get back in your pocket.
The tax breaks afforded to pensions and ISAs incentivise saving but mean that the amounts that can be paid into them are capped. So if you are looking to save in excess of the available allowances, you will need to seek an alternative home for these savings.
When looking at the alternatives, it’s very difficult to provide a definitive order in which to save as the wide variance in tax treatment means that it will come down to individual circumstances.
- Offshore Bonds – investments held within an offshore bond enjoy the same gross roll-up on the income and gains within the fund as a pension or ISA. There’s only a potential tax charge when a withdrawal triggers a chargeable gain.
But only the profit will be taxable, not the return of the original capital. Gains are taxable as savings income and if it’s possible to keep gains within the combined personal allowance and savings rate band, an offshore bond is comparable to an ISA. It’s also possible to change who is assessable on any gains. Assignments can be made to a lower rate taxpaying spouse/partner, or perhaps to children to help with university fees. In addition, withdrawals of up to 5% of the original capital can be taken without an immediate tax charge.
- Unit trusts & OEICs – unlike the other investments already covered, unit trusts and OEICs are subject to corporation tax within the fund on certain income received. Interest from cash, fixed interest securities and certain rental income will face a 20% corporation tax charge. But there’s no additional corporation tax due on dividend income received and or capital gains within the fund.
Income distributions paid by unit trust and OEIC managers remains taxable, whether it’s taken or reinvested, regardless of whether this is through investing in accumulation units or purchasing fresh units each time. The asset mix of the fund will determine whether income is paid as interest or as a dividend.
Any capital withdrawn will be a disposal for CGT. Provided gains don’t exceed the annual exemption (£11,100 2015/16) there’s no tax to pay.
But it’s possible to reduce (or eliminate) these gains by annual disinvestment and reinvestment. This crystallises gains within the annual CGT allowance each year and uplifts the base cost.
For example, an OEIC bought for £200,000 that’s worth £210,000 after a year, can be ‘rebased’, crystallising the £10,000 gain (but no tax as within £11,100 allowance). This will uplift the base cost to £210,000 which, if repeated each year, will mean little or no tax to pay on final encashment.
And remember that the CGT exemption is always available, regardless of the level of income, and that the tax rates compare more favourably than the equivalent income tax rates (i.e. 18% v 20% for basic rate taxpayers and 28% v 40% or 45% above the basic rate threshold).
Your aims in retirement may have not changed. The difference now is how you do it and the difference it will make if you do it. Saving in a way that provides the most ‘spendable’ income in retirement and which makes it easy for you to cascade your wealth tax-efficiently down the generations will be most individual’s aims.