Making the most of the tax-free ways to invest helps ensure your money grows as much as possible, with less of a slice taken out by the taxman.
Pensions and Isas (Individual Savings Accounts) both allow your money to increase without you paying tax.
Pensions and Lifetime Isas (Lisas) add an extra sweetener but have more restrictions over when you can use the investments you’ve put away.
The total amount you can save in these tax-free structures is generous – £20,000 per tax year in Isas and £60,000 a year into your pension in most cases.
But as most of us don’t have £80,000 to invest each year we need to choose which is the best structure to use.
This will depend on several factors, including your overall financial situation and plans for the cash, while many of us will be best off with a mixture. Here’s your options…
A pension
What it is:
With a pension you are saving for when you stop work so you will have more money than the state will give you once you don’t have cash coming in from a pay packet.
The government wants people to do this so they aren’t reliant on benefits in their later years, so it gives a large sweetener in the shape of a tax break to encourage people to save.
In the recent past, most pensions used to be defined benefit (DB schemes), which meant that the money you got out of them on retirement was tied to how much you earned and how long you’d been at the company, rather than what you had in your pension pot.
However, DB schemes are very expensive for employers and most of us who are saving for retirement now have defined contribution (DC) schemes, especially if we work in the private sector.
With DC schemes, what you get when you retire depends on what you saved in your working life and how your investments have grown.
If you have an employer, they must also save into your pension (unless you opt out of saving into it yourself), helping to build a bigger pension pot.
Why should I invest in a pension?
Having healthy pension savings means you can have a comfortable retirement.
When you contribute to a pension you are getting free money to help your own investments grow. This includes a tax break from the government, which adds back the tax you’ve paid on the contributions you put in, as well as a contribution from your employer. This means your investments grow even more quickly.
Most of us contribute to pensions over a long time, which is ideal for investing as studies show that over most longer periods, shares and other investments outperform cash savings.
There’s a tax break when you take your pension out too, with 25% of it withdrawn tax free.
Any reasons why I shouldn’t?
You can’t take it out until you are older. The current age is 55 but this is rising to 57 in 2028 and there’s no guarantee it won’t rise further.
You will pay tax on all but the first 25% of your pension pot when you take it out. This is paid at what is called your ‘marginal’ rate, the normal rate of tax you pay in any tax year. So, if you are a higher-rate taxpayer you could end up paying 40% or more to the taxman.
The government sometimes changes pension rules and at the moment many are concerned about whether it will restrict the amount of pension you can take tax-free at retirement.
An Isa
What it is:
An Isa is a flexible wrapper that allows you to shelter some of your money from tax. You can use it to save in cash or to invest in funds, stocks and shares, or a mixture of both.
Once you put money into it, it stays tax-free whether you keep it in one or the other, and the amount you can pay in resets each year so you can build up a large amount over time. At present you can put £20,000 into an Isa every year, splitting it in any way you like between cash and investments.
Why should I invest using an Isa?
If you don’t put investments in an Isa, the taxman will take a slice of any investment gain in value as well as any regular payments made from your investments. Although everyone has an annual allowance of gains they can make without paying tax outside an Isa, this is small and has been regularly cut by the government, so this is an important consideration.
An Isa gives you choices as you can swap between savings and investments without your money losing its tax-free status.
You don’t pay any tax on money in an Isa when you take it out, as you’ve already paid tax on it. You can take money out of an Isa at any time in your life.
Are there any reasons why I shouldn’t?
If you don’t need the money for a long time, it could grow faster with the tax breaks from a pension.
If you need to choose between putting money in an Isa or a pension and your employer also makes pension contributions, then you are missing out on free money by using the Isa.
A Lifetime Isa (Lisa)
A Lisa can only be used for certain things and for a limited amount of time and money. You can put up to £4,000 into it a year and the government adds a 25% bonus, so you have up to £5,000.
Why should I choose to invest in a Lisa?
It gives free money from the government for your first home, making it easier to save for a deposit.
Money from a Lisa is tax-free when you take it out, making that bonus even more generous.
If you are a basic-rate taxpayer, the amount of bonus you get in a Lisa is the same as the tax break you would get on a pension, so you get the same benefit, but withdrawals are tax-free too.
Are there any reasons why I shouldn’t?
Lisas are restricted to those aged over 18 and under 40. Once opened, you can contribute until the age of 50.
You can only use it to buy a first property, not a second one, and you can’t buy one worth over £450,000.
You can’t access it for any other reason until you are 60.
The £4,000 you put in comes out of your main Isa allowance, so if you put £4,000 into a Lisa you can only put £16,000 into any other Isa. This is not the same with pensions, which have their own allowances. You should always take advice from a professional if you’re not sure.
