We all know the importance of saving but with so many different options available, it can be difficult to find the best one.
Choosing the right option depends on your own personal circumstances and the goals you are trying to achieve.
Fortunately, there are simple, tax efficient options available to help us meet our short to medium- and long-term objectives, for example saving for a holiday or putting away enough to help us live comfortably in retirement.
To help you decide what is most suited to you, this blog explores the difference between two of the more common ways to save for the short to medium and long term.
You have probably already heard of ISAs (independent savings accounts). Typically, ISAs help people save for the short to medium term in a tax efficient way.
Contributions to ISAs are made after you have paid tax, but any money you take out of an ISA is tax free and you do not pay tax on any returns. You are allowed to pay up to £20,000 every year into your ISA tax free and you can transfer money already saved in other ISAs during that same year, too.
However, if you wish to pass on an ISA as part of your will it is subject to inheritance tax.
There are three kinds of ISA: cash stocks and shares; and lifetime ISA (LISA).
Cash ISAs are usually best suited to short term saving.
You can only invest in one cash ISA at a time, but you can invest in a stocks and shares ISA as well.
Cash ISAs are not invested in any assets, instead they give you a return based on the base interest rates set by the Bank of England. Different providers might give you a better return than the base interest rate, so you need to shop around.
The rates paid on cash ISAs will also depend on the type of product you have chosen. For example, a flexi or easy access ISA will usually only pay you the base rate, but you can get to your money whenever you like. Meanwhile, a regular saver cash ISA could give you a higher interest rate in return for making regular contributions into your pot. However you may not be able to get to your money for a year or have to pay a penalty for withdrawing early. Again, it is a good idea to compare providers to find the best terms that suit you.
Stocks and shares ISA
Stocks and shares ISAs are typically best suited to medium to long term investing.
As with a cash ISA you have a £20,000 allowance available to save into a stocks and shares ISA, but you can have as many as you want. However, unlike the cash ISA, your money is invested in the stock market, bonds or funds, and the value of your pot could go up as well as down. These are a good way to access stocks and share without paying capital gains tax.
You can choose to invest the money how you want within the ISA wrapper, or you can choose a provider to invest the money on your behalf. Either way you will pay fees, and these vary across products and providers, and you need to shop around for the best rates.
You can usually get to your money fairly easily with a stocks and shares ISA but you could pay to withdraw, and some ISAs might charge a fee for contributions since these are being invested for you.
A stocks and shares ISA has the benefit of being able to grow over time but there is always the risk that you could lose your money.
LISAs are suited to those saving for either retirement or buying their first home.
You must be 18 or over but under 40 to open a LISA and you can put in up to £4,000 a year, until you're aged 50. The government will add a 25% bonus to your savings, up to a maximum of £1,000 per year.
Withdrawal from LISAs are restricted. You can only take money from your ISA if you're buying your first home; aged 60 or over; or terminally ill with less than 12 months to live.
Any withdrawals made from 6 April 2021 will be subject to a 25% charge.
Pensions are suited for long-term saving for retirement.
You may have been put off the idea of pensions as boring, but they are usually the most tax efficient way to save for retirement. However, they are only accessible from age 55 and are usually only for those who want to provide for their retirement. There are two types of pension: state and private.
Everyone who has paid enough National Insurance is entitled to the basic state pension when they reach age 75 (although this age limit could increase). Although the state pension should be enough to cover the basics, it is widely seen as insufficient to provide a comfortable retirement, such as paying for holidays and treats. This is why many people choose to also save into a personal or workplace pension.
When you pay into a personal pension from your net income, the government automatically adds 25% as a top-up for basic rate tax relief. If you’re a higher or additional rate taxpayer, you may benefit from even more tax relief. The idea is that the government ‘refunds’ any income tax you previously paid on these contributions, within certain limits. As well as this, any returns in your pension are free from capital gains tax.
By law employers have to offer a workplace pension into which they and the government must contribute. The current minimum total contribution to a workplace pension is 8% of your total salary of which 3% must come from the employer and 1% is tax relief. So, if you paid in £40, your employer would pay in £30 and you’d receive £10 tax relief.
If you are self-employed or choose to opt out of your employer scheme you can set up a personal pension.
Standard personal pensions tend to offer fewer investment choices than Self Invested Pension Plans (SIPPs) which generally provide more flexibility. This additional flexibility may demand more attention from an investor than a personal pension, but many SIPP providers keep their investment options limited and simple. You can set up a pension in as little as ten minutes at Raindrop which gives you access to a straightforward range of investments.
When you reach age 55 you can access your hard-earned pension money. 25% is tax-free and the remaining 75% is taxed at your marginal tax rate. There’s also generally no inheritance tax payable on a personal pension, unless it’s first accessed when you are over the age of 75.
Which is best?
If you are a short-term saver and want to access your cash quickly, or you do not want to invest your money then the cash ISA will likely be a suitable option. For medium to long-term savers who are willing to take some investment risk but who also want to be able to access their money when they want, stocks and shares ISAs are worth investigating.
For investors who want to invest in a tax efficient way that could help ensure a comfortable retirement then pensions are a sensible choice.