The taxman doesn’t give much away, at least not voluntarily. But there’s one way that he’s far too generous according to MoneyWeek’s editor-in-chief Merryn Somerset Webb.
“Generous” and “taxman” isn’t a likely pairing from Merryn.
So how can you take advantage of this uncharacteristic generosity?
Through your pension contributions.
I’ve heard all sorts of arguments saying that you should steer clear of pensions, and just top up savings with an ISA. But for most tax payers, this is wrong.
Let your savings breed like rabbits
Now, before I get cracking, please do bear in mind that everything I’m about to say is a generalisation. Your situation may be very different to the one I describe. Before making radical changes to your retirement planning, it may be worthwhile getting some dedicated financial advice.
We’ve all heard about the powerful effects of compounding. It’s why advisers say to get stuck into retirement saving early. Over the long term, savings should grow as interest earned in turn earns more interest. Before you know it, your savings are breeding like rabbits.
Now, here’s the point. If you put extra savings into a pension (and it’s incredibly easy to set up something like an online SIPP), then your savings will get a massive shot in the arm. Say you’re paying tax at 40% and you put £6k into your pension. The tax man will top your cash up to £10k. There you go, it’s already breeding. That extra 40% is incredibly important when it comes to compounding…
According to IFA Robin Algar, saving £6k a year, leads to quite an astonishing difference over 30 years. Assuming a growth rate of 5% per annum, you’d end up with a whopping £664,000 in your pension. Compare that to an ISA plan where you’d only end up with £398,300.
Now, that’s quite a difference.
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But the taxman’s always going to get his share isn’t he?
Aaah, you tell me: “but now I’m going to get taxed as I draw down my pension.” Well, yes that’s true. But first you’ll get to take 25% tax free. In this example, that’s £166k. Pretty impressive considering you only put £180k into the fund in the first place (£6k over 30 years)! Thereafter you’ll be taxed at your marginal rate as you drawdown your savings.
But remember, if you’re earning less as a pensioner than you were during your working years, then you’re likely to be in a lower tax band. So you’ll get higher-rate tax relief on the way in and then pay a lower rate on the way out – pretty good.
Of course, nobody knows what’s going to happen with tax in the future. But given the number of retirees (read voters), I can’t imagine politicians of any colour ‘stiffing’ pensioners.
But what if I want my cash early?
It is true that ferreting away your savings into a pension means it’s not easy to get the money back early. But is that such a bad thing? I know a couple of people that have cashed in savings when they’ve been desperate – in both cases to save a failing business. Was it worth it? Nope. In both cases the business failed anyway. All they did was prolong the agony.
Remember too, that once you take cash out of an ISA, you can’t put it back in again. You’ll have to wait until the next year and use the new ISA allowance.
And if you really want to be shocked, then consider that a husband and wife on the basic state pension only get about £8k a year. Now think about whether you really want to gamble with your retirement savings.
And anyway, with a pension, you can always suspend contributions if you’re suddenly stumped for cash. The best thing is to keep some liquid assets to hand for emergencies – why on earth do you need access to your entire savings plan?
Sharpen the saw
Stephen Covey has written a lot about effective time management. He makes the point that it’s stupid to go logging with a blunt saw; better to take five minutes to sharpen it than battle away for hours with an ineffective saw.
In the same way, why would you battle away at work saving all you can, and then put it into an ineffective savings plan? Better to spend a few moments and set up something more effective. If you pay UK tax, then the chances are you’re eligible to set up a Self Invested Personal Pension (SIPP). You can usually do this over and above any other pension savings you’ve got.
[Editor’s note: follow this link to compare share dealing providers that also let you open SIPPs]
• This article was first published in the free investment email The Right side. Sign up to The Right Side here.
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