The government doesn’t want you to pay tax on your savings.
Politicians might complain loudly about tax avoidance among millionaires in certain professions being immoral (while keeping quiet about the scams they’ve got going themselves).
But when it comes to the pot you’re putting away for your retirement, they’re happy to give you two very handy tools for protecting your money from the taxman’s clutches.
Believe me, they’re not doing this out of the goodness of their hearts.
The fact is, the more money you save now, the less of a burden you’ll be on the overstretched welfare system in the future.
And given how indebted the country is, chances are that system will be even less generous than it is today by the time you retire.
So in a way, it’s not only sensible, but in fact, it’s your moral duty to make sure you avoid paying tax on your savings pot.
Let us point you in the right direction…
As mentioned last time, there are two critical tax-saving vehicles available to every British investor: individual savings accounts (Isas) and pensions.
Think of them as safes in which you can legally shelter your assets from the taxman.
Today, we’ll take a detailed look at the first of these, Isas.
How much can you put in your Isa?
Isas are quite straightforward. If you’re over 18, you can put up to £15,240 in Isas this tax year, which runs from 6 April 2015 to 5 April 2016.
You can put the money in a cash Isa, a stocks & shares Isa, or split the money between the two.
By opening a self-select Isa with a stockbroker, you can invest in a wide range of funds, shares or bonds.
In terms of restrictions on what you can put in, the most obvious is that shares have to be traded on what the taxman calls a ‘recognised stock exchange’.
This means that many shares listed on AIM (the ‘alternative investment market’, the market for small companies) are not eligible for an Isa. However, foreign stocks listed on most major exchanges are fine.
As for corporate bonds in an Isa, they have to have five years or more remaining to maturity.
Your Isa allowance is ‘use it or lose it’. In other words, you can’t hold any unused allowance from this year over to next year.
Also, once you’ve put money in an Isa, you’ve used that portion of your allowance. You can’t put £15,240 in a cash Isa this month, then take £1,000 out in May, then pay the £1,000 back in again in June.
What are the tax benefits?
Money and investments placed in Isas are sheltered from both income tax and capital gains tax (CGT). So you won’t be charged any tax on the savings interest from a cash Isa.
As for investments, you won’t get charged on any income from bonds, or on dividend income from shares.
This is good for higher-rate taxpayers, who normally have to pay 25% or more on dividends (depending on their income tax band).
It may not seem to make much difference to basic-rate payers, who don’t have to pay tax on dividends anyway. But don’t make the mistake of thinking this means you don’t need an Isa.
The CGT protection may seem unnecessary now, but in 20 years’ time when your savings have built up, it could save you a great deal.
Another benefit for anyone who fills in a tax return each year, is that you don’t have to declare Isas on your self-assessment form, which saves a bit of paperwork at least.
It also means that when you retire, any income generated from Isas won’t be counted by the taxman for income tax purposes. That could make a very big difference to the amount of income tax you have to pay in retirement.
How Isas compare to pensions
We’ll look at pensions in more detail next time. For now, here are the key differences to consider when choosing how to split your money between Isas and pensions.
Flexibility
With an Isa, if you need access to your money, you can generally get at it right away. With a pension, you can’t access your money until you are at least 55.
This is a double-edged sword of course. On the one hand, it means your money is available if you really need it. It also means your money isn’t trapped in a pension, and subject to the whims of whichever government is in power.
On the other hand, it does mean that you require the willpower to stop yourself from raiding savings you’ve earmarked for your retirement pot.
Bankruptcy
Hopefully, bankruptcy isn’t a problem you’ll ever encounter. But it’s worth knowing that if you do go bankrupt, assets in an Isa are not protected from your creditors.
In most cases, unless you’ve deliberately stashed the money there ahead of going bust, assets in a pension are protected from your creditors.
Tax treatment
The biggest difference between Isas and pensions is the timing of your tax break. When money goes into an Isa, it’s already been taxed. So once it’s in there, you pay no further tax on it – any income generated by an Isa is tax-free.
With a pension, you get your tax relief on the way in – the government gives you back the tax you’ve already paid on your money. But once you get access to your pension pot, decades later, you have to pay tax on the income that it generates. However, you can also take a 25% lump sum tax free.
What to do now
I wouldn’t advise locking your money up for a significant period of time, more than a year say. There’s too much uncertainty over how quickly interest rates might rise. But you can certainly do better than what you’re on, even with an instant access account.
• This article was updated in December 2015