Being one of the fortunate people who have crossed the 40% tax bracket, I’m often torn between the need to contribute to our underappreciated society and also the desire to create a life for myself.
As most professionals know in too much detail, once we pass the 40% bracket, any extra work is effectively taxed at 42% (including national insurance), so for every £100 we ‘earn’, we only keep £58. That is before the other taxes (council, VAT, TV and soon sugar) take their bites at the remaining cherry.
The point of this post isn’t to moan about taxes as we should all pay our fair share back to society but we shouldn’t feel frightened in trying to keep as much of that 58% as we possibly can.
Fortunately in the UK we have two main tax breaks.
The first is the individual savings account that you may have heard people referring to as ISAs. A simple way to understand ISAs is to consider them as a container in which you can store cash, stocks and shares (S&S) or peer-to-peer (P2P) lending investments.
For example, if you have £1,000 you can choose to store it under your mattress or in your bank’s current account. To be honest, not much of a difference these days! Inflation would definitely erode the purchasing power of your £1,000 over the coming years and decades though.
Alternatively you can store your £1,000 in a cash ISA which, for practical purposes, works like a bank account. The only difference is that if both your bank’s current account and a cash ISA pay out 1% annual interest, the £10 you earn is completely tax free in the ISA.
The same applies for P2P lending – if the headline rate is 5% annual interest then your £50 is tax free at the end of the year if you invest £1,000 in a P2P ISA, properly known as an innovative finance ISA (IF ISA).
With S&S, any capital gains AND dividends you receive are paid free of tax if you invest efficiently in a S&S ISA.
So why not solely invest using ISAs? Well theoretically you can but if you’re fortunate to have a decent sum of money saved up, then there are upper-limit restrictions. The maximum ISA limit this year is £15,240 but in April 2017 this will increase to £20,000. Safe to say that very few of us can exceed this amount.
The limit is spread across all three classes so as an example you can invest £5,000 into your cash ISA, £5,240 into your S&S ISA and £5,000 into your P2P ISA, totalling £15,240 for the year.
The second main tax break we should take advantage of are pensions, in particularly self-invested personal pensions (SIPPs). As the name suggests, instead of trusting a dubious investment manager (excellent ones exist but are few and far between), you control your own destiny by choosing your own investments. Again, SIPPs should be considered as containers in which you place investments into, and similar to ISAs you’re allowed to keep your investments as either cash, S&S or P2P.
However, there is one main advantage and one main disadvantage with pensions to be aware of.
The good news is that generally with every £100 you contribute into your SIPP you receive an additional £25 which automatically tops up your pension pot. You invest 80% (100/125) and the government adds 20% (25/125) as basic tax relief.
I emphasise the word generally again because individual circumstances vary greatly and certainly you may not be eligible for much tax relief if you don’t pay much tax in the first place! For example all of your earnings fall under the £11,000 personal allowance – but note that even people who don’t earn anything can still contribute and obtain basic tax relief on a maximum of £3,600 every year. Conversely, you may pay a lot of tax and be eligible for 40% or even 45% tax relief.
The bad news about SIPPs is that in contrast to ISAs, you cannot currently access funds within your SIPP until you’re at least 55. Or 57 when it comes to 2028. Etc and so on. The rules change every year.
I’m currently 26 so by the time I’m 60 the minimum pension age could well be over 70 for all we know. With pensions, you never really know whether you’ll see the money so it’s always going to be a bit of a gamble.
There are other more advanced forms of tax efficient investing which we can explore in the future but for most of us, ISA and SIPP allowances far exceed the amount of money we can save in any given year so the rest is all academic.
Remember to do your own research before investing.
P.S. I learned everything I know about finance from this book, this book and that one, amongst many others. For a more extensive list, don’t hesitate to drop me a line at email@example.com. If you prefer learning through listening use this link to earn a free audiobook of your choice by signing up to their 30-day free trial. Simply cancel with the click of a button if you decide later on that the service isn’t for you, no questions asked.