So far in this Grow it series you’ve learnt about why you should think about investing, learnt about risk, return and taxation as well as when you should seek the help of a financial adviser and how to find one you can trust.
In this episode I want to explain the basics of the account types that most people need in order to grow their wealth.
So at the most basic level you will presumably have at least one current account with a bank or building society which your wages will be paid into and your bills paid out of. Beyond that you will want an easy access savings account to store your emergency fund, with easy-access meaning that you withdraw the money quickly if you need to. This will pay a better rate of interest than your current accounts.
Now when it comes to investing there are a whole range of options. Before you get carried away thinking about the assets that you will invest in (i’ll cover that in the next video of the series) you need to decide the product through which you want to do it. These are often called tax wrappers but it’s easier if you think about them as boxes. Now three such boxes are a Stocks and Shares ISA, a pension (or SIPP) and a general investment account (called a GIA). I will explain each of these in more detail in a second.
So visualise these as boxes into which you put your investments, be they shares, bonds etc. Now generally speaking you can put the same types of assets into each box. So when you look inside each box they can look the same. But what makes each box special are the rules around not only how and when you can put money into them and take it out again but also how each box is taxed. Each has a set of rules covering whether you get tax relief on money you put into the box, how the investments are taxed inside the box as well as the tax you have to pay when taking money out of the box.
So let’s focus for second on box number 1, a pension. A defined contribution pension is a long-term savings product designed to provide you with income during your retirement. It's a tax-efficient way of investing money because you receive tax relief on your contributions on the way in, and your money grows tax-free when it is within your pension. So in simple terms when you put money in, HMRC also adds some money into the box via tax relief. There are two types of pensions: workplace pensions, which are set up by your employer, and personal pensions, which you can set up yourself. With a workplace pension it is likely that your employer will also pay into your pension as long as you do, under the terms of auto-enrolment. So not only do you get money from HMRC (through tax-relief) paid into your pension but you also receive free money paid into your pension from your employer. That is win-win and you can invest this money within the pension so it can grow.
Any money in the pension box is allowed to grow tax free however it can’t currently be accessed by most people until they hit age 55, although this age limit is set to rise. When it comes to taking money out of your pension when you retire then this is subject to income tax, although 25% of your pension pot can be taken tax-free. I won’t go into any more detail on this video but I have put some links into the notes below this video where you can find out more about how pensions work, how they are taxed and your options at retirement. One thing to bear in mind is that there are annual limits as to how much you can pay into a pension each year and receive tax-relief which for most people is the lower of your earnings in the tax year and £40,000. But generally speaking a pension is the most efficient way to invest for your retirement.
Next we move onto box number 2 which is the Stock and Shares ISA (Individual Savings Account). It is a tax-efficient account that allows you to save or invest up to £20,000 each tax year without paying tax on the interest or investment returns. You don’t receive any tax-relief when you pay into a stocks and share ISA but on the flipside any withdrawals from your ISA are always tax-free and your investments grow tax-free all the time they remain in the ISA. There are several other types of ISA other than the stocks and shares ISA. These include cash ISAs, innovative finance ISAs and Lifetime ISAs and junior ISAs.
Now I won’t dwell on the different types of ISAs in this video other than to say that your £20,000 limit is spread across all of them with the exception of the Junior ISA. However a Lifetime ISA is of particular interest to those looking to buy their first home. A Lifetime ISA offers all the attractive tax benefits of a standard ISA, but with the additional 25% bonus provided by the government. I have included a link in the notes of this video to an article on the Money to the Masses website which provides a more detailed look at Lifetime ISAs and how they work. While most LISAs out there are cash based there are some stocks and shares Lifetime ISAs that are available. Full details can be found in the article I’ve just mentioned - so if you are saving for your first home make sure that you check this out before you go any further.
This leads me onto GIAs (General Investment Accounts) which are a standard investment account that doesn't offer any tax benefits. You can still invest in a range of assets, such as stocks, bonds, and funds, but you will pay tax on any income or capital gains you make. Often people will use a GIA if they have utilised their annual ISA & pension contribution allowance.
So now you know about each box you can see that pensions offer significant tax benefits namely tax relief and the possibility of employer contributions into workplace pensions, making them a popular choice for investing for retirement. However, you can't access your money until age 55 currently.
ISAs are flexible in that you can withdraw money from them tax-free whenever you want but they also have annual limits on how much you can save. They're a good option for short-term to medium term investing goals or as a complement to a pension.
GIAs offer no tax benefits, but again they're flexible and offer access to a wide range of investment options. They're often seen as a good option if you've maxed out your pension and ISA allowances or if you need to access your money in the short term.
It makes sense to ensure that you are not leaving any free money on the table (employer pension contributions) by joining your company pension scheme and investing the money within it as you see fit. Stock and Shares ISAs complement a pension and are useful if you want to invest but have access to the money before you are 55. In reality it is not a binary choice with successful investors utilising both pensions and ISAs (and occasionally GIAs) as part of their investment strategy. The main thing is that pension and ISAs help maximise your investment returns through mitigating the impacts of tax on your growing wealth
There are other more esoteric investment vehicles out there such as VCTs and EIS which are beyond the scope of this series and only really suitable for what the regulator defines as sophisticated investors.
In the next video in the series I’m going to talk about how to pick what to invest in and build a portfolio to achieve your financial goals.
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