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Smart saving for younger savers

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AR011084 03/2018

Younger savers have three main savings options, but which one is best? In this article, we will take a brief look at the three most tax-efficient ways you can save, and which one might best suit your needs. 

Pensions 

There is a temptation to put off pension saving when you are young – after all, retirement is a long way off.

However, early contributions paid into a pension when you are young are the most important in generating a decent pension pot by the time you retire. This is thanks to the power of compound interest; any growth you get applies both to what you pay in and on any growth previously generated. So, the earlier you start, the better.

 Another good reason to prioritise pension saving is that all employees are entitled to a contribution from their employer at a minimum of 1% of pay (rising to 2% in April 2018). To get an employer contribution, the employee has to pay in 1% of earnings until April 2018 and 3% after April. But many employers are more generous than this.

You should aim to pay in enough to get the maximum contribution from your employer. If, for example, your employer will pay in a maximum of 5% of your income, if you also contribute 5%, then you should try to pay in 5%.

The final good reason why pensions should come first, is that they qualify for tax breaks. You get tax-relief on your personal contributions at your highest marginal rate of income tax. A £100 contribution will only cost a basic rate taxpayer £80 out of net income.

 And, when you do take money back out your pension, you can take a quarter of it tax-free. In the interim, your savings roll-up without any tax being deducted from investment income and gains, just like an ISA.

 A big financial no-no is opting out of your pension to save into something else, which doesn’t qualify for an employer contribution.

 Lifetime Individual Savings Accounts (LISA)

Like pensions, LISAs also qualify for tax relief. For every £80 you put in, you get a £20 bonus from the government. This applies up to an annual cap of £4,000 and, if you paid £4,000 into a LISA, you would qualify for a £1,000 bonus.

The LISA allowances eat into your annual ISA allowance of £20,000, but this is not an issue for most people. However, they are only open to people aged 18-40.  

LISAs can be used tax-efficiently for one of two purposes:

  1. To use as a deposit towards your first home (up to a purchase price of £450,000).
  2. For retirement from age 60.

If you want to save up for another purpose, such as a holiday, education fees or your wedding, then a normal ISA is better than a LISA. That is because LISAs suffer a penalty when money is taken out other than for purchase of your first home or for retirement after age 60. The penalty is higher than the bonus you receive on contributions paid in. 

When used for retirement the whole of your savings are tax-free if taken after age 60 which is better than a normal pension where only 25% is tax-free from age 55.

However, LISAs don’t qualify for an employer contribution. So, if you are using a LISA for retirement, pay into your pension what you need to get the maximum from your employer first, and only once you’ve done that, put any excess savings into the LISA.

For higher rate taxpayers who pay basic rate tax in retirement (which is true for about six out of seven working higher rate taxpayers), a normal pension is more tax-efficient.  So, higher rate taxpayers saving for retirement should just pay any excess savings into their pension rather than a LISA.

 

ISAs

ISAs are the best savings option to target needs other than retirement or the purchase of a first home. Funding education, second and subsequent house purchase, buying a car, saving up to get married and so on.

Although you don’t get tax relief or a bonus on money paid into an ISAs, no tax is paid by the ISA on any interest, dividends and investment growth received.

And, you can get your hands on ISA savings whenever you want. This flexibility makes ISAs a great short-term savings option.

In summary

  • Prioritise your pension and pay in what you need to get the maximum amount off your employer.
  • If you are saving up for your first home and you are under 40, think about saving up your deposit in a LISA.
  • Basic rate taxpayers who have already got the maximum pension contribution from their employer, can consider putting excess retirement savings into a LISA.
  • Higher rate taxpayers saving for retirement should probably put excess savings into their pension.
  • Normal ISAs are best for everything else and can be accessed any time you want; you don’t have to wait until you purchase your first home or retire.
    

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