Better to have, and not need, than to need, and not have. – Franz Kafka
The Efficient Way
Saving and investing are the gateway to financial freedom, and with the right information and know-how, what you put aside as investment has the potential to grow exponentially. Money does buy you happiness, security, and comfort, and with a myriad of savings and investment platforms out there, knowing where to put your hard-earned cash can seem like a daunting task, especially when you try to factor in investment fees, and income/dividend tax. The taxman is more than happy to have your money, especially when you are not aware of some of the legal ways you could exploit to avoid paying too much tax on your savings and investments. This article will highlight some of the possible tax efficient accounts you could make use of here in the UK, and save you some money on tax.
When it comes to investment fees, the consensus is to go for ETFs (Exchange-traded Funds) or Index funds, which are both forms of low cost investing. These funds can charge anywhere between 0.05% up to 1% in fees (even more in some cases). Personally, I feel anything above 1% is very expensive, especially if you are just starting out as an individual investor. Just to do a bit of mathematics, 1% of a £500,000 investment could mean £5,000 in yearly fees – just to simplify things here. £5,000 is a lot of money, and now imagine that figure multiplied over the number of years you wish to stay invested in a particular fund, and this is not taking into account growth of principal, because as your money grows, the fees increase as well.
The financial perceptive advocate for tracker funds as being the cheapest form of investing, costing you less in fees, and bumping up your earnings in the end. Tracker funds simply track stock market indices like the S&P 500, and thereby reducing management costs, unlike actively managed funds, which can be very expensive. Tracker funds are a passive form of investing and could be a good starting point for those new to investing. The argument for avoiding actively managed funds is that only a few have ever outperformed the markets, with the majority obviously under-performing. Going for tracker funds would be the safe bet for the novice, since speculating which fund will beat the markets could be more risk than what one is willing to take.
Personally, I feel if you understand what you are doing, then go for what feels right by you. It might also be helpful getting help from a financial adviser, though it is not a necessity if you are well versed in the subject. Either way, there is no harm in seeking out advice through the various sources available to us, as you could never go wrong with acquiring the right kind of information.
Different Types of ISAs
With the ISA limit having gone up to £20,000 a year from 2017 under the conservative government, maximising on this opportunity is a wise move when it comes to protecting your wealth from income gains tax, and any form of tax on investments. ISAs are a tax efficient way to save and invest, because all the interest you earn is tax free for the rest of your investing life, as long as your investments stay wrapped up under those accounts. Currently, you can only contribute to one of each of the ISAs per tax year (from 6th of April to 31st of March). The beauty of it is that you can diversify your money across the five different ISAs and contribute to each one to make up your £20,000 limit collectively. Most of these ISAs come with a £85,000 cash guarantee if regulated by the FCA, and please check before you make a deposit or investment.
Having said that, here are the 5 major ISAs you could make use of in each tax year. Mind you, things might change every financial year, so always be up to date with information.
- Cash ISA
Cash ISAs are great for general short-term savings, but not for long-term savings (5 years or more). The interest rates on Cash ISAs is quite low, especially if you go for high street banks, which are currently offering anything between 0.25% up to 1.25% if you are lucky. However, online banks are offering a slightly higher interest if you do your research well. Depending on the type of account you go for, interest is usually paid annually.
Fixed Rate Cash ISA: These ISAs are for locking cash away for a set time, i.e. 1 – 2 years, even more with some accounts. By law, cash ISA providers must allow you access to your money whenever you need it, though this might come with a hefty penalty.
Cash ISAs are a good way for saving up for things like your first car, or vacation, and for college or university fees if you have to pay for your education. They are perfect for short-term goals that do not require a huge interest pay out or growth on principal, though we are all in favour of favourable interest rates.
- LISA (Lifetime ISA)
Launched on 6 April 2017, this special ISA is for anyone aged between 18 and 39 and comes with a 25% government bonus. The maximum you can save per year in this ISA is £4,000, and for every £4,000 you save, the government gives you £1,000, so that is £5,000 a year, plus interest on any investments you make if you decide to go for a stocks and shares LISA, and all of this is tax free. You can max out this LISA every year until your 50th birthday, which could amount to a total savings of £161,000 excluding interest on investments, and dividend payments. Again, this is tax-free.
The catch: You can only withdraw money on either your 60th birthday, or when you want to buy your first property worth up to £450,000 in London, and £250,000 elsewhere, otherwise you incur a 25% withdrawal penalty, which is a loss on your government bonus.
The LISA is ideal for saving up extra tax-free money for your Golden years apart from your pension alone. Depending on the type of lifestyle you would want to live after 60, an extra boost in income could prove beneficial. I would encourage going for this option, and doing some more research of your own to assess whether it is a suitable option for you. Also, bear in mind that the £4,000 limit makes up part of the £20,000 ISA yearly limit.
- Help to Buy ISA
This is for those saving up to buy their first home. For every £200 you save, the government give you a 25% bonus again – that is £50 for every £200 saved. Currently, the maximum government bonus you can receive is £3,000. If you do it with your partner, you could get up to £6,000 collectively, as this is per individual basis, and not per household. When you are close to buying your first home, you will need to instruct your solicitor or conveyancer to apply for the government bonus, which then must be included with funds consolidated at the completion of the property transaction.
The help to buy ISA is available from a range of banks, credit unions, and building societies.
- Stocks and Shares ISA
The stocks and shares ISA is another tax efficient way of investing and saving, especially for the long-term. With the new government rules that came into effect in 2014, you can now split money between stocks and shares ISAs and Cash ISAs any way you like.
A stocks and shares ISA allows you to invest your money into bonds, shares, and funds and earn tax-free interest on all investments held. You do not need to pay capital gains within an ISA, which is great if you exceed the annual capital gains tax allowance. For example if you buy shares at £2,000, and then sell them for £3,000, you would have made a £1,000 gain and might have to pay tax on it – which is avoidable in this ISA.
From April 2018, dividends will be tax free up to £2,000, anything above that will incur a tax fee according to your tax band. However, dividend income received on shares held in a stocks ad shares ISA will be tax-free. The same applies to cooperate bonds; if you have cooperate bonds, or bond funds within an ISA that pay out interest, you do not have to pay tax on them!
Any interest earned outside of an ISA will charged tax, is also applies to dividends above the £2,000 allowance.
- The Innovative Finance ISA (IFISA)
The innovative Finance ISA is a new type of savings account similar to the traditional cash ISA but potentially paying up to double more interest. It allows savers using peer-to-peer (P2P) lending platforms to receive tax-free interest on investment. Peer to peer lending cuts out the “middle man” bank, allowing borrowers to pay less in interest, but also allowing investors to receive more.
Savers can use part, or their entire £20,000 ISA limit in this ISA like all other ISAs, or you can allocate money across different ISAs to make up the £20,000 collectively.
Other Tax Efficient Ways to Invest
- Pension Funds
Putting money into a pension fund is a no brainer, and the earlier you start, the better off you will be! I started my contributions when I was 25, and I wish I had started earlier. Again, the experts recommend saving up to at least 15% of your gross income into a pension fund, you can do the math. There could not be anything wiser than saving up for your golden years to avoid being a burden to your family and children because of no money. Many people over the age of 50 find themselves with no tangible savings to last them through to 90, and so the need to keep working tirelessly in your late years just to keep up with expenses.
The good books says, “A good man leaves an inheritance for his children, and his children’s children”! Now that should speak volumes on the state of our financial affairs, especially if we have children. Leaving a pile of bills and debts for your family after you are gone will not promote a good reputation. Why not do the wise thing, and start saving up for the so-called retirement years. With a pension fund, for those on the basic tax rate, all your contributions get up to 20% tax relief on contributions up to your annual earnings. Moreover, for those on a higher tax rate, they get 40% relief for contributions up to £40,000, which is their annual limit. Let us say you earn £100 before tax, and decide to invest £80 into your pension pot, for those on basic tax rate, the government pays you back £20 in tax relief into your pension pot totalling it back up to £100, if you invest £60, then your total pot contribution amounts to £80 and so forth.
For the highest earners, there is a £1 million annual limit, and what this means is that if your total pension savings (including interest and gains) are over this amount, you will not receive further tax relief on further contributions.
Start Sooner: With pensions, the sooner you start, the longer your money has to grow. This is when the compounding effect works in your favour, interest starts earning interest on interest, attracting additional earnings to your pot, and making a huge difference.
Start Now: For those who might be late on the bandwagon, there is no better time to start than now no matter what age you are. What matters is that you play catch up and invest as much as you can into a pension fund. Always picture the life you would want to live a few years down the line, and save according to those aspirations.
Increase Payments: Increase payments whenever you can to help boost your savings. With every pay rise, you could add that increment to your pension pot instead of spending it (Watch out for lifestyle inflation when you get a pay rise). The more money you put away, the more interest you gain, and the more your pot grows.
There is a lot of information on pensions out there, if you have time, go deeper into the subject so that you get an understanding of how pensions work.
- VCTs (Venture Capital Trusts)
I only recommend VCTs for the sophisticated investors with an annual income of over £100,000, as they carry a high degree of risk. Make sure you only invest in VCTs if you have money to play around with, and if losing that money will not put a strain on your finances. VCTs are higher risk and longer term than conventional investments, and I only recommend VCTs for those who have used up their ISA and pension allowances.
VCTs are another tax efficient way of investing as the government gives a 30% tax break on new VCT fund raising. VCTs are companies that invest in start-ups/ small firms to help them grow, and there is no guarantee that you could make a good return on investment, though historically they have performed really well. Profits are generally paid to investors as tax-free dividends, which are the primary source of return for investors, and there is no capital gains tax to pay when you dispose of the VCT.
VCTs can be hard to buy and to sell. They are attractive to long-term investors, with a view of staying invested in them for 3 to 7 years before selling their share of the company.
Please note: As with any other type of investments, you could get back less than what you initially invested. This is not financial advice, but information on the various accessible platforms for saving your money. For financial advice, seek appropriate help from a financial adviser.