UK “tax wrappers”: pay less on your profits


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Important: This article was originally written by Finimize. Any opinions offered are those of Finimize and not of CMC Invest.
This information is for guidance purposes and may become out of date at any given time. It is not investment advice. Investments can rise and fall in value. CMC Invest won’t make any assessment of whether the investments you choose are appropriate or suitable for you. If you are unsure of the suitability of any investment, investment service or strategy, you should seek independent financial advice. Past performance does not indicate future results. Your capital is at risk.
Understanding ISAs
Whether you’re keeping your savings in cash, or investing in things like stocks and bonds, your returns can be liable for tax. To reduce the amount of tax you have to pay, you’ll need a tax wrapper.
The most common form of tax wrapper in the UK is an Individual Savings Account (or ISA). Any money you make from savings or investments contained within an ISA is completely tax-free. You’re allowed to invest up to £20,000 each year, and depending on your goals there are several to choose from. You can even spread your money across several different kinds of ISA, as long as you don’t deposit more than the £20,000 limit in any one tax year.
What are cash ISAs?
First up are cash ISAs. These are the simplest type of tax-free account. They’re literally just cash savings accounts, but you don’t have to pay tax on the income you earn from interest. You can choose to be able to withdraw your money at will, or lock up your savings for a fixed length of time. In return for the lock-up, your bank will normally reward you with a slightly higher interest rate.
What are stocks and shares ISAs?
Then there are stocks and shares ISAs. A stocks and shares ISA is just like an investment account you would have with a broker or fund manager, but, once again, any returns you get are tax-free.
What are innovative finance ISAs?
Finally, there’s the innovative finance ISA, which offers tax protection for peer-to-peer lending (or P2P lending). P2P is kind of like the Tinder of investing: it matches people wanting to borrow with those wanting to lend out their cash. Returns are generally higher than those you’d get from a Cash ISA, but the risk involved is higher too. As far as ISAs are concerned, innovative finance ISAs ensure you’re not taxed on your P2P returns.
What are lifetime ISAs?
Those are the three broad categories of ISA, but to confuse things further, there are also a couple of special categories for people at different stages of their life. If you’re under 40 and looking to save for the long term, or maybe for that first house, a Lifetime ISA may be your thing. They offer free money. Like, actually free money. The government pays a 25% bonus on the amount you put in each year. Although it’s worth noting that you’re only allowed to put £4,000 of your annual £20,000 allowance towards this type of account each year – so your government bonus is capped at £1,000 per year. But what the government gives, the government takes away. You have two options with your Lifetime ISA: either keep the money in it until you’re 60, or use it to buy your first home. If you take the money out before you’re 60 for any other reason, you lose the government bonus.
What are junior ISAs?
Last but not least, there’s the Junior ISA. This allows you to save money on your children’s behalf. There’s an annual investment limit of £4,280, but that’s in addition to your own allowance.
A word of caution on the ISA: use it or lose it! Your annual ISA allowance can’t be carried over to the following tax year, so if you don’t use part of it, it’ll disappear when your allowance resets each April. And because ISAs are a great tax wrapper, a general rule of thumb is to use your ISA allowance first. If you’ve got money left over, then it’s time to look at pensions.
The takeaway: ISAs let you invest in stocks, cash, or P2P lending, and a Lifetime ISA offers a bonus from the government that you can use when you buy your first home or retire.
Understanding Pensions
Like an ISA, a pension is just a way for you to legally avoid paying so much tax on your savings. The UK government wants you to save for your old age, so it gives you a tax break to encourage you.
Of course, pensions are only useful if you don’t need access to your money before retirement, but they’re important to think about if you dream of sipping cocktails and taking luxury cruises in later life. Or even just having enough cash to heat your home. You might need more than you think to retire comfortably.
The contributions you make to your pension come straight out of your salary and don’t attract any income tax upfront, making them “tax-efficient”. This effectively means the money you put in your pension is boosted by at least a quarter – just like with the Lifetime ISAs we talked about in the last session. After you retire, you’ll have to pay tax on the income you take from your pension, but this will probably be less than the tax you’d have to pay if you were still working. And your personal tax allowance will allow you to get at least some of your money out each year, completely tax-free.
Your pension is really just an investment product like any other, although if you work for a company and are enrolled in their pension plan you might have only limited choice about where exactly your money is invested.
The massive plus side of company pensions, however, is, yep once again, free money. Many companies will match at least some of their employees’ pension contributions each month – so if you funnel, say, 10% of your salary into your pension your employer might add another 8%. The precise figures will depend on the terms your employer offers. Make sure to ask what they are – if you earn more than £512 a month, they legally have to contribute at least 3% of your salary.
Because of this free money from your employer, you may well be better off maximizing your pension contributions before you do any direct investing yourself. And if you want more control over where your pension money is invested you may be eligible to take the reins yourself and transfer your funds to a Self-Invested Personal Pension, or SIPP.
What is a SIPP?
A SIPP allows you to pool together pensions from previous jobs, as well as any private policies you may have, and invest them in a wide range of assets. You can select and manage your investments yourself, or have a professional investment manager make the decisions for you. Managing your pension in this way can become expensive, so keep an eye out to make sure you aren’t stung with high fees.
But as we said earlier, pensions are only useful if you can do without your savings until retirement. If you need them earlier, there’s another product for you.
The takeaway: Pensions are another tax-efficient way of investing your savings, and if your employer matches your contribution, you’re getting free money too.
The General Investment Account
If you’ve maxed out your annual £20,000 ISA allowance and still have money kicking around that you want to access before retirement, it’s time to salute the General Investment Account, or GIA.
Investments within a GIA incur taxes on any income you receive, like dividends or interest, as well as on any increase in the value of your investments – which are known as capital gains.
There are some allowances. Depending on how much tax you already pay elsewhere, like your salary, you might be eligible for a Personal Savings Allowance. This relieves you of tax payments on some or all of your savings’ interest income. The same is true of the dividend allowance too, though only up to a certain limit. Everyone is also allowed to realize a few thousand pounds worth of capital gains each year without having to pay tax.
Of course, investments in stocks or bonds can fall in value as well as rise. If you can’t handle that idea, you should stick with a plain old savings account. If you’ve maxed out your ISA allowance these too will attract the attention of those pesky tax officials – but only for any interest earned beyond your Personal Savings Allowance. Over the long term the returns from a savings account are likely to be lower than from investments in a GIA. But you won’t have to worry about the chance your investments could drop in value.
In this Pack, you’ve learned:
You can stick up to £20,000 each tax year into an ISA and you won’t have to pay any tax on those returns.
Funnelling money into your pension means you’ll pay less income tax and your employer might also match some of your contributions. You won’t be able to touch the money until you retire though.
If you’ve maxed out your ISA allowance and don’t want to lock up money until retirement, then look into opening a standard savings account or a General Investment Account.