Chapter 2

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Saving for Your Retirement

Savings in the UK

‘Twenty years from now you will be more disappointed by the things that you didn’t do than the ones you did do.’

Mark Twain

Saving for retirement is central to your financial plan. It means avoiding spending a portion of your income today, accumulating it and spending it in the future after retiring. In other words, it is giving up consumption today for future consumption.

Saving is not easy. It requires discipline, self-control and long-term vision. It involves taking some of your disposable income and, instead of enjoying it, putting it away for many years. When retired, your quality of life probably depends on your savings. It is as simple and as important as that.

Psychologist Walter Mischel conducted a series of studies over 50 years ago called the marshmallow experiment. Children sat in a room alone and were offered one marshmallow immediately or two marshmallows if they waited 15 minutes. About 25% of children passed the test, resisting immediate satisfaction. They had self-control and ability to delay gratification.

Later, studies found that those who passed the test were more likely to do well academically and socially than those who did not. They did better at overcoming problems in life; they were more successful in their career and were less likely to suffer from obesity, alcoholism and drug abuse.

Not only do you need to delay some satisfaction all your life, by saving for retirement, but also pension freedom means a possibility of instant gratification when you retire – you can take your savings and spend them. This calls for extra discipline and self-control.

The objective of saving for retirement is for your money’s value to grow as much as possible over the long term. However, you cannot just forget about it. Rather, you need to take good care of it so it grows well.

First, think about the income you will need to live on in retirement. Next, consider how long you will need that income to keep coming in. Finally, calculate how much you need to save to generate that income for the expected period.

The amount of money you accumulate is a function of four variables:

1. Contributions. When saving, you make contributions into your saving pot. For example, regular contributions from your income or lump sums if you get a bonus. It is a balance between consumption today and contributions.¹
2. Growth. Savings earn interest or generate income and capital gains through investing. Growth is measured in real terms, above the rate of inflation. The trade-off between growth rate and investment risk is one of this book’s main focuses.
3. Time. More time enables more contributions and allows interest and investments to work longer. Start saving and investing as early as possible and delay retirement for as long as possible.
4. Costs and charges. Expenses, including taxes and fees, reduce savings. Be as stingy as possible with costs and charges without compromising the quality of your savings and investments. We will review some practical ways to do this.

We will explore three main saving channels: ISAs, pensions and paying off mortgages on residential property. This chapter details ISAs and pensions. Chapter 11 focuses on residential property.

Admittedly, this chapter includes some boring material, such as taxes. If you wish, skip it and come back to it later. The reason to start with it is not to put you off reading the rest of the book, but rather to first understand tax fundamentals. Taxes have a huge impact on savings and wealth. Understanding how taxes work helps minimise them.

Consider getting professional advice on taxes. This book does not replace such advice. It scratches the surface of the delightful world of taxes. It does not include, for example, any creative tax-avoidance schemes or estate planning.

Income tax and Capital Gains Tax

‘The hardest thing to understand in the world is the income tax.’

Albert Einstein

We begin with a review of income, dividend and capital gains tax. The reason to start with taxes is that to appreciate the tax benefits of tax-efficient saving wrappers, such as ISAs and pensions, first we need to understand taxes. Before finding a solution, understand the problem.

Income tax

You can put savings in your bank savings account. However, its major disadvantage is tax. When earning interest on savings in the UK, you pay income tax.

The standard tax-free Personal Allowance is £11,000 for each tax year (£11,500 from April 2017).² Income, interest on savings and rental profits above the Personal Allowance are taxed, depending on how much of them fall within each tax band.^3,4 The UK follows a progressive tax system, taking a larger percentage from the income of high-income earners than it does from low-income individuals.

For income, including interest and rental profits, up to £32,000 above the Personal Allowance (£33,500 from April 2017), the basic rate is 20%. For income between £32,001 (£33,501 from April 2017) above the Personal Allowance and £150,000, the higher rate is 40%. And for income over £150,000 the additional rate is 45%.

If you are a basic-rate taxpayer with up to £1,000 interest on savings, your bank or building society will pay it tax-free. If you are a basic- or higher-rate tax payer with interest on savings above the Personal Savings Allowance (see endnote 3) HMRC will collect the tax due by changing your tax code. If you fill in Self Assessment, carry on doing so to calculate and confirm your taxes on savings.

If you are a higher-rate taxpayer, for example, every additional £1 you earn as interest on savings above £500 falls under the higher rate. So, 40 pence goes to the taxperson, leaving you 60 pence. Now, wouldn’t it be nice to keep the whole £1 to yourself?

Paying 45%, 40% or even 20% on interest and income is significant. When saving for multiple years, this really bites into your savings.

For example, you have saved £100,000, you earn 5% annual interest and you are on the higher tax band (40%). In 10 years’ time, you earn gross interest of £62,900.⁵ Your net after tax interest is £40,124.⁶ You ‘lost’ £22,766. Isn’t that a shame?

Dividend tax

Since April 2016 tax on dividends from stocks (shares) has changed. The first £5,000 of dividend income in each tax year is tax-free (Dividend Allowance). Above it, basic-rate taxpayers pay tax at a 7.5% rate, higher-rate taxpayers at 32.5% and additional-rate taxpayers at 38.1%.

No tax is deducted at source. You must use Self Assessment to pay the tax due. Dividend income is still eligible for Personal Allowance. For example, if you receive £17,000 dividend income, Personal Allowance covers the first £11,000 and Dividend Allowance another £5,000. You will pay dividend tax only on £1,000. Dividends earned in ISAs and pensions are not taxed.

Capital Gains Tax (CGT)

CGT is levied on profits you make when disposing of assets that have increased in value.

You do not pay CGT if your profits in the tax year are below your tax-free CGT allowance, called Annual Exempt Amount (different from Personal Allowance). The Annual Exempt Amount is £11,100 or £5,550 for assets held in a trust.⁷

Disposing of an asset includes selling it, gifting it (except to your spouse, civil partner or charity), swapping it or getting compensation for it, such as insurance if it was lost or destroyed.

CGT is levied on chargeable assets. These include personal possessions worth over £6,000 apart from your car; property that is not your main home; your main home if you let it, use it for business or it is very large; investments (stocks, units in unit trusts, and certain bonds but excluding UK Government gilts, Premium Bonds and Qualifying Corporate Bonds); and business assets.

When holding assets overseas you may need to pay CGT when disposing of them. There are special rules for UK residents who are non-domiciled (non-dom status).

CGT rate is 20% for higher or additional-rate taxpayers. It is 10% or 20% for basic-rate taxpayers, depending on their capital gains and income. An additional 8% surcharge applies to residential property, so the rates are 18% and 28%.

You can reduce your total taxable gains by deducting certain costs of buying, selling or improving chargeable assets. Also, if you make a loss in a tax year (allowable losses) you can reduce gains and carry forward unused losses to a future tax year.⁸

Report capital gains, cost deductions and losses in your Self Assessment.

For example, you bought a Van Gogh painting for £200,000 and sold it for £250,000. Your gain is £50,000. You incurred costs of £6,000 when buying and selling the painting, such as the auction house’s fees. Your net gain (chargeable gain) is £44,000.⁹ Your taxable gain is £32,900, which is the chargeable gain minus the Annual Exempt Amount of £11,100.

If your total income (including salary, interest and rental profits) is more than £43,001 (£45,001 from April 2017) you are a higher-rate taxpayer.¹⁰ Your entire taxable gain is taxed at 20% and your CGT is £6,580.¹¹

If your total income is below £43,001 (£45,001 from April 2017) you are a basic-rate taxpayer. Some or all of your taxable gain is taxed at 10%.

For example, your total income is £30,000 meaning £13,001 of your basic-rate band is available.¹² The first £13,001 of your taxable gain is taxed at 10% and the rest at 20%. You pay total CGT of £5,280.¹³

This is not as complicated as it seems. When completing Self Assessment online, HM Revenue & Customs (HMRC) calculates your taxes, as long as you input the correct figures. Keep records of all your gains and expenses to make Self Assessment quick and easy. Keep records of your Self Assessments for at least six years.

Tax-efficient savings

Taxes are a hefty charge on savings and investments. Minimising them can save a fortune.

It does make sense to keep some cash in your current and savings bank accounts. You need cash for everyday life and a cash reserve for emergencies.

How much cash do you need as a reserve?

The old rule of thumb calls for easy-to-access cash covering three to six months of expenses. However, it depends on two considerations. First, how long it would take you to land a job if you lost your current one. If it would take about six months, keep cash on hand for at least six months of expenses. Second, it depends on how financially secure you feel. Build your stash to your comfort level.

If you are saving for the long term, shelter as much as you possibly can from tax. The British Government gives two simple and quite generous ways to do so: ISAs and pensions.

ISAs

An ISA is a tax-efficient account.¹⁴ It is not a deposit or an investment. Rather, it holds or wraps within it savings or investments – it is a wrapper.

ISAs allow tax-free saving. At present you can save up to £15,240 each tax year in ISAs (£20,000 from April 2017), choosing between two types: cash ISAs and stocks and shares ISAs. As long as your savings are in ISAs you pay no taxes on interest, income and capital gains. You do not declare any interest or profits on your ISAs in your tax return. It is all completely tax-free.

You can save the entire £15,240 (£20,000 from April 2017) in one ISA or split it between a cash ISA and a stocks and shares ISA, however you want. You can save in your ISAs any time during the tax year.

Cash ISAs enable you to save with banks, building societies and some National Savings & Investments products. Stocks and shares ISAs enable you to invest in stocks, unit trusts, investment funds, corporate bonds and government bonds.¹⁵

ISAs are flexible, giving easy access to your money. You can make a withdrawal from your ISAs at any time without losing your tax benefits. You do not pay any taxes when withdrawing money.

Since April 2016 ISAs have become more flexible. Savers are now able to withdraw cash from cash ISAs and stocks and shares ISAs and put it back in in the same tax year without losing their tax entitlement. This enables savers to hold emergency cash in ISAs.

ISAs are transferable. You can transfer them from one provider to another or a cash ISA to a stocks and shares ISA and vice versa.

Like every other financial product, shop around for the best ISA deal. For cash ISAs consider interest rates, whether it is a fixed (check notice or term) or variable rate and what the charges are. For stocks and shares ISAs consider available investments and charges.

If you are unhappy with your ISA provider, switch. Your provider and you are in a business relationship, not a friendship. It is nothing personal. However, mind the potential costs of transferring ISAs.

Transferring cash ISAs normally should not cost you anything, but there could be penalties, in particular on fixed rate ISAs. Also, your money can spend up to 15 working days moving between providers, not earning interest during this time.

Transferring stocks and shares ISAs might incur costs of closing an account and transaction costs of selling and buying investments. Your investments could be sold or bought at the wrong time and spend time out of the market.

ISAs are great to save and invest within a tax shelter. Use your entire ISA allowance every tax year, do not lose it. Even if you do not want to invest, park the money in cash ISAs, transferring it to stocks and shares ISAs when deciding to invest.

Here is an example to demonstrate ISAs’ benefits. Assume you are a higher-rate taxpayer, saving £10,000 every year. You can choose between a taxable savings account, offering an annual 3% gross interest rate, or a cash ISA, offering a 3% tax-free annual interest rate. After 20 years you save £242,481 in your savings account and £276,765 in your cash ISA. That is an extra £34,284 in the ISA because you did not pay income tax.¹⁶

A new Lifetime ISA (Lisa) will be available from April 2017, allowing savers under 40 to save up to £4,000 a year until the age of 50 and receive a government bonus of 25% on their savings, up to £1,000 a year. You can use the savings to buy a first home (worth up to £450,000) at any time from 12 months after opening the account or withdraw them tax-free from the age of 60 (withdrawal under other circumstances will lose the government bonus and incur a 5% charge on the remainder).

Pensions

Pension choices in the UK are plentiful. Understanding the different types of schemes, each with its advantages and disadvantages, will help you choose one suitable for your circumstances, investment style and needs.

Pension savings focus on efficient tax planning, minimising charges and enhancing investment returns. When drawing from your pension also plan to minimise taxes. To do so, know your legal rights and obligations.

The Pensions Advisory Service (TPAS) at www.pensionsadvisoryservice.org.uk provides free, independent and impartial information and guidance on pensions.

Defined benefit (DB) pensions

Are you a member of a DB pension?

A DB scheme is normally a valuable and increasingly exceptional benefit.

Calculate the income you are expected to receive from your DB pension. Normally, income is calculated using a formula, considering three variables:

1. Pensionable service. The number of years you have been a member of the scheme.
2. Pensionable earnings. This could be your final salary, an average of some of your salaries over your career (career average) or another formula.
3. Accrual rate. The percentage of the pensionable earnings you receive as a pension for each year of pensionable service. Typically, it is 1/60 or 1/80.

For example, if your pensionable service was 20 years, your pensionable earnings are £40,000 and the accrual rate is 1.67%, your annual pension income is £13,333.¹⁷ That is gross £1,111 per month and £1,072 net of income tax (£1,081 from April 2017).¹⁸

Your benefits may be linked to inflation or increase by a set amount. Often, benefits increase by Limited Price Indexation (LPI): usually annual inflation rate, capped at 2.5% or 5%, with a floor of 0%. However, this is not mandatory. If benefits are not linked to inflation, their real value diminishes over time, in particular when inflation is high.

Normally, you can take benefits from the age of 65. Some schemes allow you to start taking benefits from 55, but this usually reduces your pension income. You may take benefits without retiring. You may be able to defer taking benefits, possibly increasing them. When you die, your spouse, civil partner and dependents typically get paid a fixed percentage from your benefits (commonly 50%).

Taking your pension as a lump sum may be possible when reaching 55. Up to 25% of the sum is tax-free; the rest is taxed.

The Pension Protection Fund protects DB schemes. This should cover cases where the sponsor becomes insolvent or the scheme does not have enough assets to pay benefits. However, the protection might not cover the full amount.

Boosting DB pensions

You can boost your expected benefits through additional voluntary contribution (AVC) and free-standing additional voluntary contribution (FSAVC) schemes.

AVC schemes may be offered by employers, letting employees on DB schemes contribute to DC schemes or buy additional pensionable service in their DB scheme.¹⁹ FSAVC schemes are not connected to any employer. They are DC schemes offered by insurance companies.

The sum of your employer’s contributions into your DB and your additional contribution into AVC/FSAVC schemes need to fall under your annual allowance to enjoy a tax-relief. These concepts are explained later.

If you are in a private-sector DB pension or a funded public-sector scheme you can transfer to a DC scheme if you are not already taking benefits.²⁰ This is rarely a good idea. It could be a good idea if: you want to retire early and avoid your DB scheme’s penalties; you want to retire late and wish to invest your money in a DC pension; you have ill health and do not expect benefits for long from your DB pension; you are single so no spouse will benefit from your DB pension; or, based on your lifestyle, you do not want income.

Defined Contribution (DC) pensions

If you are not a member of a DB pension, save in a DC pension, which is a ‘wrapper’ to hold your investments until you retire and start drawing income.

Are you employed or self-employed? If you are employed, your employer should arrange a workplace pension for you. If you are self-employed, arrange a stakeholder or personal pension for yourself.

In the next sections we will review different DC schemes, clarifying the terminology.

Workplace pension

A workplace pension (occupational or company pension) typically is arranged and provided by large employers.²¹ Often, they make contributions into the pension. You can also contribute into it.

Multi-employer pension

Since October 2012, a new system of automatic enrolment for workplace pensions has been phased in.²² By 2018 most workers will automatically be made members of a workplace pension and employers will pay in contributions on the employees’ behalf. Currently, contributions are relatively modest, but it is planned to ratchet them up over coming years. The employer chooses the scheme, which must meet minimum standards. In many cases, employers use a multi-employer pension (master trust).

Some employers offer their own workplace pension. A multi-employer pension works like a workplace pension but it is provided by an organisation that is not the employer (pension provider or pension administrator).

NEST pension

NEST (National Employment Savings Trust) is a low-cost pension you can join through your workplace or if you are self-employed. NEST is a DC workplace pension master trust set up by the Government. Many employers are likely to choose NEST for auto enrolment. Check www.nestpensions.org.uk.

Personal pension

In a personal pension you choose the administrator and arrange for your contributions to be paid into the pension. You can choose investments from a range of funds offered by the provider. If you do not have a workplace pension, use a personal pension.

Personal pensions may be offered through your employer. These are called group personal pensions (GPP). The employer selects the pension administrator, but the pension is an individual contract between you and the provider.

If you change jobs, your GPP usually is converted automatically into a personal pension and you can continue paying into it independently. Check whether your new employer offers a pension and compare it with your GPP. Focus on charges and available investments. You can stop paying into the GPP, paying into your new pension instead, or transfer your old GPP into the new pension.

Stakeholder pensions

Stakeholder pensions are a type of a personal pension. They must meet minimum standards set by the Government, including low and flexible minimum contributions, capped charges, charge-free transfers among investments and a default investment strategy if you do not select your investments.

Employers offering a stakeholder pension select the pension administrator and may arrange for contributions to be paid out of your wages or salary. Employers may contribute to the scheme. You can set up a stakeholder pension for yourself. It is suitable if you are self-employed or on a low income.

SIPP

A self-invested personal pension (SIPP) is suitable for experienced investors. SIPPs are designed for people choosing and managing their investments. SIPPs allow freedom to deal with your investments and switch among them when you want.

SIPP is the preferred pension to manage your own investments. When choosing a SIPP, always shop around.²³ Different providers offer different investment choices and charges. You want the widest choice for the lowest charge.

If you have a number of DC pensions, consider consolidating them. It can make it easier to manage and charges could be lower when having more money invested with a single provider. However, consider any transfer charges and exit penalties.

If you have changed jobs over the years and lost track of your DC and DB pensions, the following steps can help:

1. List all the companies for which you worked.
2. Check correspondence on pensions.
3. Contact their human resources (HR), asking for info on your pensions.
4. Use the Government’s free Pension Tracing Service at www.gov.uk/find-lost-pension.

Retirement age and drawing income

The retirement age in the UK is 55 – that is pretty young.²⁴ You can access your DC pension in any way you wish from that age.

You can take your whole pension pot as a lump sum. A quarter (25%) is tax-free (called pension commencement lump sum – PCLS) whilst the rest is subject to tax at your income tax rate. A large lump sum can move you into a high tax bracket for the tax year, meaning it is an inefficient tax plan.²⁵

You can take the tax-free lump sum whenever you want after the age of 55. You can use it for a well-deserved holiday or pay off debt. Keeping the money in the pension, however, allows it to continue growing, sheltered from tax. You can choose to take either the first 25% of your pension tax-free or 25% of each withdrawal tax-free. The latter option is more tax-efficient, especially if your pension portfolio grows over time.

Consider taking up to a quarter as a tax-free lump sum, using the rest to withdraw lump sums as and when you need, drawing regular taxable income (income drawdown) and/or buying a taxable retirement guaranteed income, known as annuity. They are subject to tax at your normal marginal tax rate during each tax year.

When you want to start drawing income, you can transfer your pot into Flexible-Access Drawdown (FAD). You can choose to delay taking money out – you do not have to buy an annuity or transfer to FAD. The untouched pot is called uncrystallised funds. You can make one-off cash withdrawals from your uncrystallised funds, known as uncrystallised funds pension lump sum (UFPLS, pronounced ‘ufplus’).

Drawdown describes accounts where, typically, most of the money remains invested but savers can take cash out regularly or as needed. Phased retirement is a process of taking your pension assets in stages. By using only part of the accumulated pension savings each year, you create a tax-efficient income stream.

National Insurance Contributions (NICs) are not levied on pension income, including the tax-free lump sum.

Advice

Pension Wise (www.pensionwise.gov.uk), a service offered by the Pensions Advisory Service and Citizens Advice, offers free and impartial guidance. Pension Wise cannot advise which option is best for you or how to invest your pension savings.

Consult a regulated financial adviser. Use the website www.unbiased.co.uk to find one. Financial advisers charge a fee for their services. However, there are more details and subtleties to pensions than what is covered briefly here. They may be pertinent to your specific circumstances. Seek advice but use your own common sense.

Self-employed and State Pension

Being self-employed, you need to arrange your own pension. No employer arranges it for you. There are no employer’s contributions. And irregular income patterns can make regular saving difficult.

Whether self-employed or employed, you may be eligible for basic State Pension. Currently, the full basic State Pension is set at £119.30 a week (£6,204 a year). Getting the full amount requires 30 years of NICs.

People retiring on or after 6 April 2016 (men who were born on or after 6 April 1951 and women who were born on or after 6 April 1953), can be eligible for the new State Pension. Its full amount is £155.65 a week (£8,094 a year).

The simplified new State Pension replaces the current system that includes top-ups, such as pension credit for people on a low income. In theory, everyone can eventually get the same amount. However, in reality, there will be wide variations in payments since you need 35 years of NICs to qualify for the full amount.

Calculate your expected State Pension based on current law at www.gov.uk/calculate-state-pension. State Pension age is not the same as retirement age. Check your State Pension age at www.gov.uk/state-pension-age.

And that is it. That is what you get from State Pension, unless for example you had periods of unemployment during your working life or you are eligible for Pension Credit if retired on a low income. State Pension is unlikely to be sufficient to maintain your current standard of living. So it is crucial you save for retirement.

Tax relief, annual and lifetime allowance

Your employer’s contributions into your pension are tax-free since they are deducted from your pre-tax pay. HMRC tops up your contributions into a pension as part of income tax relief. If you are a basic-rate taxpayer, for every £100 you contribute into your pension, HMRC adds an extra £25.²⁶ This is the advantage of pensions over ISAs.

However, tax on pensions might transform in the future. Instead of the current tax-exempt contributions and investment roll up and tax when withdrawing (EET), it might change to tax on contributions and exempt investing and withdrawing (TEE, like an ISA). This is dubbed pension ISA.

Pension administrators typically claim tax relief at the basic rate, add it to your pension and invest it within two to six weeks. If you are a higher-rate or additional-rate taxpayer, claim the additional rebate through your tax return. You will get the rebate directly; it will not be added to your pension. After reaching the age of 75, no tax relief is granted on contributions. Tax relief may change in the future, moving to a flat rate for everyone, instead of a rate equal to your marginal tax rate.

Starting as early as possible to save in your pension allows you to benefit more from contributions, tax relief, growth through investing and compounding.

For example, you contribute £100 per month for 40 years from the age of 25 to 65. You are a basic-rate taxpayer (HMRC tops up each £100 contribution by £25). Assuming 5% average annual investment return and an annual charge of 0.75%, your pension pot will grow to £154,693. Without tax relief, the pension pot would grow to £123,754, so that’s an extra £30,938 due to tax relief.

Starting 20 years later and contributing £200 per month, your pension pot will grow to only £93,784 with the tax relief. By starting 20 years later, you saved nearly £30,000 less, even when doubling your contributions.

You can contribute into your pension as much as you want each year. However, there is a limit on the amount for which you get a tax relief. The maximum yearly amount benefiting from a tax relief is called annual allowance. Currently, it is £40,000 (including your and your employer’s contributions). From April 2016, your lifetime allowance (LTA) is £1 million, including contributions and investment growth (if you are a high earner read endnote 27).²⁷ If the value of your pension pot tops the LTA, you could be hit with a tax penalty when accessing the pot or when reaching age 75.

No tax relief is awarded on higher amounts. However, you can carry forward unused allowance from three previous years.

If your income varies from year to year, use unused allowances to maximise your pension savings in years when your income is high.²⁸ Even with unused annual allowance carried forward, tax relief is limited to your annual income for the specific year. If you save more than your annual allowance, you may have to pay a tax charge, which is added to your taxable income through your Self Assessment and taxed at your marginal tax rate.

Pension payments follow 12-month input periods. These do not follow the tax year and may differ if you pay into different schemes. The tax year in which an input period ends determines the annual allowance that is applied.

If you can, use your entire annual allowance. Carry forward any unused tax allowance from the previous three years. After three years, unused annual allowance is lost forever.

For example, in 2015 you contribute £20,000 to your pension, not using £20,000 of your £40,000 annual allowance. In 2016 your annual salary is raised to £45,000. You live like a hermit and want to contribute as much as possible to your pension. Although you carry forward £20,000 unused annual allowance from 2015, taking your annual allowance to £60,000 in 2016, you can contribute only up to your £45,000 annual salary.

In 2017, your annual salary jumps to £70,000 (living like a hermit paid off). You carry forward £15,000 from 2015 and 2016, taking your annual allowance to £55,000 in 2017. Since your annual salary is higher, you can contribute the entire £55,000 into your pension.

Once you withdraw money from your pension under certain conditions (trigger event) after the age of 55, your annual allowance drops to £10,000 (money purchase annual allowance – MPAA) for all your DC schemes. You cannot top it up with unused allowance from previous years.

Boosting DC pensions

If you are a member of a workplace pension, often employers offer contribution matching. They agree to contribute to your pension up to a certain limit if you increase your contributions. This is a valuable benefit – effectively a free salary increase. Take advantage of it to its maximum, if you can afford living with a lower current income.

Additional Voluntary Contributions (AVCs) are normally available for DC pensions. Use AVCs to top up contributions to your annual allowance.

A salary sacrifice is an arrangement where you, as an employee, reduce your cash income in return for some form of non-cash benefit, such as an additional contribution into your DC pension. The contribution can be exempt from both income tax and NICs.

Salary sacrifice can be beneficial for both you and your employer, who does not need to pay Employer’s National Insurance on the sacrificed sum. Generous employers can pass some or all of these savings to you.

For example, you earn £28,000 a year and decide to sacrifice £1,500 of your salary in return for your employer paying an extra £1,500 into your pension. Your take-home pay, after tax, NIC and your own pension contributions, falls from £20,452 to £19,492. But the value of your total take-home package, including employer’s pension contribution, increases from £20,452 to £20,992. You are better off by £540.

Inheritance tax (IHT)

IHT is due if your estate is currently worth more than £325,000 (Inheritance Tax threshold).²⁹ The IHT rate is 40% on anything above the threshold. Transfers of any assets between spouses upon death are IHT-free.³⁰

There are two types of transfer for IHT purposes: a chargeable lifetime transfer and a potentially exempt transfer. A chargeable lifetime transfer creates an immediate 40% IHT charge if accumulated transfers within the past seven years exceed the £325,000 threshold. A potentially exempt transfer is not liable to IHT as long as the donor does not die within seven years of the gift.

In most cases, pensions are not counted as estate for IHT purposes since pensions are a legal trust. Fill in a nomination form, naming who should inherit your unused pension assets upon death.

Consider naming your children instead of your spouse to inherit your pension. The spouse gets all property IHT-free, whether it is a pension or not. Leaving your pension to your children is a way to mitigate IHT since they do pay IHT on other assets.

Unused pensions used to be subject to a 55% pensions death tax, which was applied from the first £1 without a tax-free band, as with IHT.³¹ Luckily, this ruinous tax was abolished.

When someone dies before the age of 75, the recipients of unspent pension pay no tax. When someone dies after 75 (as in most cases), recipients (not just dependents) of unspent pensions are taxed at their marginal income tax rate. They can minimise tax by spreading drawdowns over different tax years. In effect, it puts the recipients in the same position as the deceased.

Pensions are a tool for minimising IHT, allowing for cross-generational estate planning. This is one reason residential property cannot be owned inside a pension; otherwise, it would have been used to avoid paying IHT on homes.

As for ISAs, surviving spouses inherit their spouses’ ISAs tax-free without losing the tax shelter of assets in the ISAs. For other recipients, the tax sheltering is lost. ISAs form part of the estate and are subject to IHT.³² Draft a will, leaving your ISAs to your spouse to avoid IHT. It is recommended to draft a will anyway, not only to mitigate taxes, but also to avoid long probates and ensure your estate reaches your intended beneficiaries.

Consider setting up a trust for estate planning. As opposed to common belief, trusts are not the exclusive privilege of the super-rich. Trusts can be instrumental in mitigating IHT, as well as controlling the ability of beneficiaries to spend assets. Take professional advice from a solicitor to design a trust fitting your needs and special circumstances.³³

Savings for children

Cash ISAs are available for UK residents aged over 16. Stocks and shares ISAs are available for UK residents aged over 18.

Everyone in the UK under 65 earning up to £11,000 (including wages and interest, £11,500 from April 2017) per year does not pay income tax. Most children do not get anywhere near this, so they do not pay tax on their bank’s savings account.³⁴ Some banks offer attractive interest rates on children’s savings accounts up to a certain amount.

However, if money given to children by each parent generates interest above £100 per year it is taxed at the parent’s marginal tax rate. Also, once the child earns more than the Personal Allowance, income tax kicks in.

Consider a Junior ISA for your children under 18. The annual saving limit for a Junior ISA is £4,080.³⁵ You can choose between a cash Junior ISA and a stocks and shares Junior ISA. Your child can have either one or both and can take control of it at the age of 16, starting withdrawing money at 18.³⁶

The money is locked in until the child turns 18. This could be good (long-term disciplined savings) and bad (inflexibility). Then, the Junior ISA converts to a standard ISA. The child benefits from accumulation of the allowances used all the years in the Junior ISA. Otherwise, unused allowances are lost. The child has full control of the money at the age of 18 – not you.

Often, cash Junior ISAs offer higher interest rates than bank savings accounts. However, the choice in stocks and shares Junior ISAs is quite limited since it is a relatively new product.

Junior ISAs are great to save for your children’s wedding, house deposit and first car. You are likely to end up helping them anyway, so start tax-efficiently saving for it.

University tuition fees is another reason to save. However, do not rush to pay your children’s tuition fees. First-time undergraduates can get the fees paid by the Student Loans Company. They need to repay the loan only when earning enough (over £21,000) after graduation. Run the numbers to check whether paying the tuition upfront is better or worse than taking the loan and repaying it much later.

You can open a pension for your child. It sounds crazy, but it allows saving for your children’s future. Children’s pensions benefit from a tax relief at the basic rate, up to a maximum of £3,600. On every £2,880 you contribute per year, the Government adds £720.

Children can take control of the pension when they are 18, but they can access it only at the age of 55. They will not be able to spend it like they could do with a Junior ISA when reaching 18.

Start saving for your children’s retirement. They will thank you one day.

Maximising pension contributions for a couple

If you do not pay tax, you can still pay into a personal pension, benefiting from a tax relief at the basic rate up to a maximum of £3,600. You can contribute into someone else’s personal pension, like your spouse, civil partner, child and grandchild.

If your spouse does not work, consider contributing to your spouse’s personal pension to benefit from tax-efficient saving and tax-relief at the basic rate. If your spouse works and on a higher tax band than you, gift money to your spouse to contribute to your spouse’s pension to enjoy a tax relief at a higher tax rate. Together, you and your spouse can maximise pension contributions up to your combined annual allowance. Annual allowance is personal so you have one and your spouse has another one.

Insurance

Insurance is an important part of your financial plan. Different kinds of insurance help protect you and your loved ones against the costs of risks such as accidents, illness, disability and death. Such risks cannot be left unmitigated.

Life insurance is crucial if you have dependents. It pays a lump sum or regular payments when you die to help your surviving dependents to maintain their standard of living, repay debt (such as mortgage) and fund education tuition costs.³⁷ If you are employed, your employment package can include death in service benefits, covering you for a multiple of your annual salary.

Income protection insurance pays an income stream if you are unable to work. It is especially critical if you are your household’s main provider.

And this was the most boring and technical chapter in the book – guaranteed. However, it includes important information and tips about how to maximise your tax-efficient savings. I am glad we have got it out of the way.

Article 2.1

Source: Evans, J. (2015) Retirement savings: how much is enough? Financial Times,

19 August, www.ft.com.

© The Financial Times Limited 2015. All Rights Reserved.

Summary

• Saving for retirement is part of your financial plan.
• The amount you save is a function of: (1) contributions; (2) growth; (3) time; and (4) costs and charges. Maximise contributions, growth and time, whilst minimising costs and charges, including taxes.
• Progressive income tax is levied on your personal income, interest on savings and rental profits. Tax rates on dividends from stocks are different, but the bands are the same. CGT is levied on capital gains. Minimise taxes using ISAs and pensions.
• Shop around for the best interest rates and lowest charges for cash ISAs and consider available investments and charges for stocks and shares ISAs.
• If you have a DB pension, boost it through AVC/FSAVC schemes. DB schemes are normally rare and valuable. If you have one, do not give it up lightly.
• SIPP is the most flexible DC pension to manage your own investments.
• If you have a number of DC pensions, consider consolidating them. You may reduce charges when investing more with a single provider.
• Use your entire annual allowance or carry forward unused allowance from three previous years. Aim to use your entire lifetime allowance.
• Insurance is a critical part of your financial plan. Life insurance protects your dependents after you are gone.

Notes

¹ Personal savings or household saving ratio in the UK averaged 6.4% from 1955 to 2015, according to the Office for National Statistics. As of the third quarter of 2015 it was 4.4%. Household saving ratio is the percentage of disposable income that is saved. Total savings = disposable income – household consumption.

² The Personal Allowance may be bigger for people who were born before 6 April 1938 and for those who get Marriage Allowance or Blind Person’s Allowance, or smaller if your income is above £100,000 (it is reduced by £1 for every £2 income in excess of £100,000).

³ From April 2016 no tax is deducted on the first £1,000 on interest earned every year on savings (Personal Savings Allowance). The allowance is £500 for earners on higher tax rate and nil for earners on additional tax rate. This may make cash ISAs redundant for some savers.

⁴ Rental profits are rental income minus allowable expenses or allowances.

⁵ £62,900 = £100,000 (1 + 5%)¹⁰ - £100,000.

⁶ Net interest is after reducing 40% of interest above the £500 Personal Savings Allowance every year.

⁷ In common law a trust is a relationship whereby one party holds property for the benefit of another. The settlor transfers property to the trustee. The trustee holds the property for the trust’s beneficiaries.

⁸ When you report a loss, the amount is deducted from your capital gain in the same tax year. If your total taxable gains are still above the tax-free allowance, you can deduct unused losses from previous tax years. If they reduce your gain to the tax-free allowance, you can carry forward the remaining losses to a future tax year.

⁹ £44,000 = £250,000 - £200,000 - £6,000.

¹⁰ £43,001 = £11,000 + £32,001.

¹¹ £6,580 = 20% × £32,900.

¹² £13,001 = £43,001 – £30,000. From April 2017 the threshold for paying the high-rate 40% tax will increase from £42,385 to £45,000. So instead of £13,001 it will be £15,001 = £45,001 – £30,000.

¹³ £5,280 = 10% × £13,001 + 20% × (£32,900 – £13,001).

¹⁴ In 1999 ISAs replaced both Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs).

¹⁵ Self-select ISAs allow you to select individual securities and Exchange Traded Funds (ETFs). You can use online brokers who operate on an execution-only basis whereby they offer no advice, only a security dealing service for low charges.

¹⁶ Calculations assume annual compounding, a constant interest rate, without considering inflation. You can easily find free online ISA calculators.

¹⁷ £13,333 = 20 × £40,000 × 1.67%.

¹⁸ £13,333 – £11,000 = £2,333 taxed at base rate of 20%, which is £467 per year or £39 income tax per month. £1,072 = £1,111 – £39. From April 2017 use £11,500 instead of £11,000 in the calculation.

¹⁹ Benefits from additional pensionable services can be taken only when those from the main scheme are taken.

²⁰ The value of the assets of a funded DB scheme exceeds that of its liabilities. The scheme is in surplus. An unfunded scheme is in a deficit.

²¹ The Pensions and Lifetime Savings Association (PLSA) offers ample information and guides focusing on workplace pensions at www.plsa.co.uk. A Small Self-Administered Scheme (SASS) is a trust-based occupational DC pension with relatively wide investment flexibility. It generally has less than 12 members and mostly appropriate for the company’s directors and senior and key staff.

²² The Pensions Regulator at www.pensionsregulator.gov.uk offers information on automatic enrolment and other topics on work-based pension schemes.

²³ Thorough analysis of costs and providers of SIPPs is available at www.telegraph.co.uk/sipps.

²⁴ The retirement age is expected to increase to 57 by 2028. State Pension age is expected to increase as well and to continue doing so in the future as life expectancy increases.

²⁵ If you are under 75 and your life expectancy is less than one year due to serious illness, you may be able to take your whole pension pot as a tax-free lump sum. If you are over 75, you will pay 45% tax on the lump sum.

²⁶ £100 = £125 × (1 – 20%). After deducting the 20% basic tax rate from £125 you are left with £100.

²⁷ Since April 2016, the size of annual allowance is reduced gradually from £40,000 to £10,000 for those earning between £150,000 and £210,000 a year (including their employer’s pension contributions). You can carry forward unused annual allowance of £40,000 from previous years even when you are subject to a reduced annual allowance. From 2016 onwards the amount of carry forward will be based on the unused tapered annual allowance. Lifetime allowance was £1.25 million until April 2016. The lifetime allowance applies to an individual’s entire pension savings (excluding State Pension). If pension benefits may exceed lifetime allowance, consider applying for one of several forms of lifetime allowance protection (check www.gov.uk for details).

²⁸ You must be a member of a pension scheme during the years you want to carry forward.

²⁹ The inheritance tax threshold is £650,000 for a couple. The Government plans to increase the threshold for a couple from April 2017 with an additional £100,000 (rising over the following three years to £175,000) allowance for each partner when passing on their primary residence.

³⁰ There is no IHT on gifts that married couples or civil partners give each other (as long as they live permanently in the UK). Otherwise, the original owner needs to live seven years after gifting the gift. If they do not, their estate or the person receiving it must pay IHT. The amount due is reduced on a sliding scale if it was given between three and seven years before the person died.

³¹ If the pension has not been touched and the person died before the age of 75, unspent pension was inherited tax-free.

³² ISAs are exempt of IHT on stocks traded on AIM (the London Stock Exchange’s market for smaller companies) held for at least two years.

³³ Check www.gov.uk for ways to reduce IHT. Explore www.advicenow.org.uk for information on rights and the law.

³⁴ You may need to fill an R85 form and give it to your bank to get interest without tax taken off. Ask your bank.

³⁵ Before the introduction of Junior ISAs, Child Trust Funds were available. You cannot open a Junior ISA for a child with a Child Trust Fund. But you can transfer the Child Trust Fund into a Junior ISA and start saving in a Junior ISA.

³⁶ You can open one cash Junior ISA and one stocks and shares Junior ISA per tax year, splitting the £4,080 allowance between them as you wish.

³⁷ Whole-of-life insurance is designed to give a specified amount of cover for the whole of the customer’s life. It pays a lump sum on death. Term assurance policy is designed to pay a lump sum if the customer dies within the plan’s term. The customer chooses the lump sum amount and period of cover. Terminal Illness Cover and Critical Illness Cover can be included.