ISA, LISA, or pension? What’s the best vehicle (or combination of vehicles) for you to get the most out of your retirement?
Modina looks at the three dominant saving products on the market at the moment.
As we’re comparing ISAs, LISAs, and pension schemes to see which one may be better for your retirement, we’re not considering factors in this article like the easy of drawing cash out of your ISA, LISA, or pension and any penalties attached to doing that – we’re going to assume that when you put money into these accounts, it’s going to stay there until you’re at least 55.
What is an ISA?
There are lots of different types of ISAs. For the purposes of this article, we’re not going to cover Junior ISAs or Help to Buy ISAs (designed to help people buy their first property).
An ISA is an account which allows you to save or invest money where you pay no tax on the interest you receive or returns on investments you make. An ISA financial year runs from 6th April to the 5th April. On every 6th April, your new allowance takes effect. At time of writing (financial year 2017/18), your allowance is £20,000 per annum. Tax rules are constantly changing and your exposure to particular benefits will depend on your personal circumstances.
In 2017/2018, you can invest up to £20,000 in a combination of three different types of ISA – a cash ISA, an investment ISA, or an innovative finance ISA.
A cash ISA is provided by banks and building societies. It’s like a normal savings account but you don’t pay tax on the interest you receive.
An investment ISA, sometimes called a stocks and shares ISA, as an account provided by fund supermarkets and stockbrokers. In this type of ISA, you can place company shares, unit trusts, investment trusts, government and corporate bonds, and open-ended investment companies.
Modina wealth warning 1 – your savings may diminish in value if the investments you choose (or the investments your advisor chooses) reduce in value. There is greater risk of loss in investment ISAs than cash ISAs.
Currently, regardless of whether your investment is in an ISA or not, you are allowed to claim the first £5,000 of dividends on your investments tax-free (over £5,000, there is a 7.5% tax for basic rate payers, 32.5% for higher-rate payers, and 38.1% for additional-rate payers).
Modina wealth warning 2 – The £5,000 tax-free dividend allowance may drop to £2,000 from financial year 2018/2019.
However, if your investments are contained within your ISA, you will avoid tax on dividends altogether.
Everyone has a capital gains tax allowance of £11,300 per year (2017/2018 tax year). Capital gains tax only becomes payable when you sell your investment – you don’t pay it on rises in value you have not crystallised by selling yet. With an investment ISA, you pay no capital gains tax on investments contained within it.
Many investment ISA holders put their money into interest-bearing assets like bonds and gilts. As they’re wrapped up in the ISA, they don’t attract tax, meaning a 20% saving for a basic-rate taxpayer (40% for higher-rate payers and 45% for additional rate payers).
Innovative finance ISA
Innovative finance ISAs are investments in peer-to-peer lending, like Funding Circle, Zopa, and Ratesetter. This is a riskier way to make money from interest than, say, government bonds (the UK government has never defaulted on a debt and while that cannot be ruled out in the future, the likelihood of it happening, from an objective point of view looking at the relevant statistics, is much lower than lending money to a company or individual via a peer-to-peer lending site).
Currently, any interest you earn on a peer-to-peer lending platform would be covered by the Personal Savings Allowance. With this, basic-rate tax payers can earn £1,000 a year in interest without paying tax. For higher-rate payers, this figure is £500.
With an Innovative Finance ISA, any interest you receive is tax free.
Modina wealth warning 3 – companies you invest in via your innovative finance ISA may go bust. While many peer-to-peer sites have compensation funds, you can’t rely on the to cover any or all of your investment should a firm you’ve backed cease trading.
What is a LISA?
A LISA is a Lifetime Individual Savings Account. You can use a LISA to buy a home or to save for retirement. For this article, we’re going to look at someone investing in a LISA with the goal of building up their retirement funds.
LISAs can only be opened by those aged from 18 to 40.
You can have cash LISAs or investment LISAs – at time of writing, innovative finance LISAs are not available.
You can allocate up to £4,000 of your £20,000 ISA limit to lifetime ISAs. Over the course of your lifetime, you can contribute a maximum of £128,000 (before bonus payments) to your LISA.
Every time you put £1 into your LISA, the government will add 25p. So, if you invest £4,000 in your LISA in a year, the government will top that up by £1,000. Your first bonus is paid at the end of the first year. From 2018/2019, the bonus is paid every month, allowing you to benefit from compounding.
When you reach 50, you won’t be able to pay into your LISA anymore and you will no longer earn the 25% bonus. You can withdraw the money without penalty from the age of 60 with no tax to pay on the withdrawal.
How do pensions work?
Anyone over the aged of 18 can start a pension and contribute up to £40,000 a year to their pension, subject to a lifetime limit of (at time of writing) £1m.
You receive tax relief on every contribution you make – 20% at basic rate (equivalent to LISA), 40% at higher, and 45% at additional. Contributions and growth are both tax free.
Under the new auto enrolment pension rules, your employer will make a contribution of 3% of your salary between £5,876 and £45,000 a year from 2019/2020 – and you’ll have to contribute 5% yourself (unless you opt out).
You can withdraw the money from the age of 55 freely but withdrawals will be subject to tax over a certain level.
Well, for us at Modina, the introduction of LISA is a good thing – it’s another way to get Britain saving.
ISAs and the new LISAs are very flexible financial tools however the money you pay into it is money you’ve already been taxed on. With pensions, you receive tax relief on the contributions you make.
With ISAs and LISAs, you’re the only person paying money into it. With a pension, the company you own will put money into your pension as will the government. While this will cost your company money (which can be deducted from profit for corporation tax purposes), you are not personally having to make the contributions.
In addition, for higher rate tax payers and additional rate tax payers, government pension contributions are generous. To have £1,000 in your pension pot, a higher rate tax payer needs to put in £600 and an additional rate tax payer £550. In a LISA, you would have to put in £800 to achieve the same.
On the other hand, if you’re at the maximum level of contributions for your pension and want to save more, an ISA or LISA could be a better option. Self-employed higher rate taxpayers gain more from a pension because the tax relief is bigger than the lifetime ISA bonus but the picture for self-employed basic rate taxpayers is not straight forward.
The picture is further complicated for everyone depending on whether you’ll have taxable income after retirement or not.
Talk to us – we know people
Modina are bookkeepers – that’s what we do and we love doing it. But we do have lots of friends in the industry who are accountants and tax planners.
If you want to work out the best way to save for your retirement, let us connect you with some brilliant minds on the subject. Please call your Modina team on 020 7183 8241 or email firstname.lastname@example.org and ask how we can help.