I have some spare cash which I’m willing to put away for the long term.
Should I open an investment Isa before this year’s deadline, or pay extra into my pension?
Investment Isa versus pension: What’s the best way to save in the long run?
Tom Selby, senior analyst at AJ Bell, replies: There are a number of things to consider when deciding whether to top up your Isa or pension.
First of all, for most people it is not an either/or decision – providing you haven’t used up all of your allowance in either product, you can choose to pay into an investment Isa AND a pension before the end of the tax year.
In fact, for many people this will be the most sensible approach. The extent to which you go for one over the other will mostly depend on your priorities.
Investment Isas are a good option if you want to benefit from tax-free investment growth while retaining the flexibility to access some or all of your pot tax-free at any time.
Pensions, on the other hand, require you to lock your money away until age 55. In return for this you don’t have to pay tax on the money you pay in – in the jargon, you get tax relief at your ‘marginal rate’ of income tax.
Just think of this as a savings bonus from the Government.
Tom Selby: ‘It makes sense to utilise as much of the £40,000 annual tax-free pension allowance and the £20,000 Isa allowance as you can afford’
A quarter of the money you take out after age 55 is also tax-free, with the rest taxed in the same way as income.
In practice, this means if you’re a basic-rate (20 per cent) taxpayer getting £100 into your pension will only cost £80, with the extra £20 added automatically by your provider through tax relief.
A higher-rate (40 per cent) taxpayer can also claim back an extra £20 in tax relief through their tax return, while additional-rate (45 per cent) taxpayers can claim back an additional £25.
The combination of free money through tax relief and the ability to withdraw 25 per cent of your fund tax-free means that for most people (and particularly higher earners), pensions offer the best retirement savings deal – provided you are comfortable not getting at your money until age 55.
The good news this tax year is there is no rush to use up your pension tax allowances ahead of a significant reduction, as has been the case on several occasions since 2010.
That said, it makes sense to utilise as much of the £40,000 annual tax-free pension allowance and the £20,000 Isa allowance as you can afford – particularly with a Budget on the horizon later this year.
How to check if you are close to breaching the Lifetime Allowance
Use This is Money’s pension calculator, which will show you both your projected retirement income and final savings pot, based on relatively conservative investment returns.
Answer seven quick questions, and on the final page there are options to click on both projected income and savings.
It’s also worth noting that while the pensions annual allowance is £40,000 for most people, this is not the case for everyone.
Anyone who has used the pension freedoms to take a taxable income from their pot from age 55, for example, will be subject to a much lower £4,000 annual allowance.
Similarly, savers with total earnings above £150,000 could also have a lower pensions allowance, with the level gradually reducing to a minimum of £10,000 for those with total earnings of £210,000 or more.
If you think you might be affected by this it’s worth speaking to a regulated financial adviser to discuss your options.
Wealthier savers should also check they are not bumping up against the Lifetime Allowance before making extra contributions.
The Lifetime Allowance is the maximum you are allowed to put in a pension during your life and still qualify for tax relief.
There are hefty tax penalties if you breach the limit, which is currently £1million but is due to rise to £1,030,000 in 2018/19.
I want to drip feed money into an investing Isa – is it still possible this close to the deadline?
You can open an Isa and opt for phased investments over time, or put your money in an Isa cash park and leave it for now. Read more here.
Whether you opt for an Isa, a pension, a Lifetime Isa (see below), or a combination of products, you should also consider how you pay your money in.
There are two options: make a single lump sum payment or drip feed on a regular (usually monthly) basis.
Clearly, if you are aiming to make use of your allowances before the end of the tax year you will be looking at lump-sum investments.
But you can open an investment Isa before the deadline, and then either phase payments in slowly over the coming months, or let the money sit in a cash park until you are ready to invest.
The advantage of drip-feeding is that it can help smooth out any significant movements in the stock market because you are buying investments at different prices as you go.
For example, when markets fall you can benefit from buying stocks and shares at lower prices.
What about the Lifetime Isa?
There’s also another savings product, the Lifetime Isa, which could be attractive to some younger savers before the end of this tax year, writes Tom Selby.
The annual allowance is lower than a normal Isa at just £4,000, but any money you save is boosted by a 25 per cent Government bonus, up to a maximum of £1,000.
This is the same as the savings bonus available to basic-rate taxpayers through pensions.
Withdrawals are tax-free provided you’re using the money to buy a first home worth £450,000 or less, are aged 60 or over, or fall into terminal ill health.
However, any other withdrawals will be hit with a 25 per cent Government charge, meaning you might get back less than you put in.
In addition, this product is only available to people aged 18-39, and only from a handful of providers.
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