Pension vs. ISA – the Saga continues

There is a huge amount of debate around when it comes to the Pension vs. ISA question. For me the answer is easy – both! The ISA debate is more complicated now that there is the LISA, Help to Buy ISA, and god only knows what others coming (and ISAs were supposed to be simple?!), but there are pro’s and con’s to each. I know this has been done to death all over the FI community and in the papers, but I thought I would add my take on it, so feel free to skip if you are bored of this!

It seems clear that the government is continuing to push people away from using pensions, mainly to target increasing their tax take now, rather than in the future (in my opinion). This to me seems very short sighted as it discourages people from saving for retirement and forcing people to lock their money away and not fritter it away when the feeling takes them.

I also like the idea of in effect deferring my tax (I pay too much IMO, but then I suspect everyone thinks that!). I will pay tax on it at some point when I start to withdraw it from the wrapper, but given the new freedoms I can see that I should be able to minimise the tax, which maybe why they are after it now. How much I can avoid paying tax on I don’t know, but I expect I will still take a tax hit in some way.

In the UK, especially if you are after FIRE, then you may also want to consider other options of investing, however for a couple you have two lots of £40,000 in the form of pension contributions (assuming of course you don’t earn too much), and now two lots of £20,000 post tax income that you can shelter in tax efficient manners. If there is still money left after that, then you can look at Buy to Let (although this is becoming less efficient investing with the tax changes), pay down your mortgage (assuming of course you still have one), or invest in a non tax sheltered account (not that attractive with the tax implications on dividends but a way to take advantage of Capital Gains Tax). There are lots of ways to keep your tax bill to a minimum.

For the sake of this post I am only looking at the Pension vs. ISA side, if you are able to fill both of these, and more, then fair play 🙂 Further, I am only considering Defined Contribution pensions, rather than the rare unicorn that is Defined Benefit.

Pensions

Most people put the minimum amount they can in, to the default fund, forget about it and don’t look at it until they are almost ready to retire and then wonder why they aren’t even going to be able to afford Aldi own label bread. To me this is a problem with the financial education, people should take the interest, even if it is only tracking to see that they are not having their savings eaten alive by fund charges. With the death of gold plated Final Salary schemes these days it is even more important – the onus is on the individual to make sure they can save enough.

When you start out working in your 20’s, knowing that you can’t access the money for over 30 years seems a tough one – I certainly never had any doubt that I would be alright, but that was some form of self belief and confidence that I had when I was young! If you are wanting to stop working at 40, tying up your money until you are 55 (or maybe even longer depending on government changes), this may not seem sensible.

For what it’s worth – when I first started working I would have been able to access my pension at 50, not so now. Had they not changed these rules than I would definitely be able to retire at 50, now it is a bit more tricky.

Pro’s

  • Tax relief. I don’t think this can be underestimated – whilst not massively beneficial to a 20% tax payer, to a 40% or 45% (subject to allowance) this is a huge perk. I put in my (highly) taxed money, it automatically gets ramped up by the basic tax relief, then I complete my self assessment form and either have a higher tax free level / monthly income for it, or I get a nice little bonus once a year with the refund. If you are in the 40% (or 45%) bracket, I think it’s madness not to put money into your pension and get as low down the tax bracket as possible, accepting the restrictions this may have
  • Handling your income band. This has the advantage of keeping you tucked under a specific banding, be it 40% tax, 45% tax rates, child benefit reductions, the £100k 60% trap or so forth. Nothing else can help like the pension can here and can have a material change on your take home pay as well
  • Safe from any bankruptcy issues. Whilst I would guess the probability of someone who is interested in getting to FI is much lower than average, you never know what the future holds. If you are declared bankrupt or hit issues, people can come after your regular savings and ISAs to help settle bills, whereas your pension is safely tucked away and can continue to grow
  • A fairly hefty contribution allowance (unless earning over £150k) of £40,000 per year means you can keep a large amount of wealth outside of the taxman until retirement – provided you earn that much of course
  • Tax free lump sum available (I need to look into more to see how best this can be utilised from a tax planning perspective). So not only do you get to put in money, tax free. It also grows, tax free. You can then withdraw 25% of the pension, tax free! This is an incredible perk (how long it will last is another matter) – in effect I am expecting to be able to take out nearly all of my contributions (cash equivalent) when I can access my pension, meaning that everything else in the pension is grown capital. How cool is that?!
  • Employer contributions. By law, employers have to provide a work place pension now, and also contribute to it. No matter how small, even 1% extra helps, so it is further free money that you wont get if you don’t join it, so sign up, take an interest, and invest!

Con’s

  • You can’t access it until 55+, a real drag for a lot of people who are looking for FIRE. Knowing that you may have 5, 10 or maybe even more years before you can get at the money after your targeted FIRE date means you may end up delaying your freedom date because you can’t access the bulk of your funds
  • The Lifetime Allowance (LTA). Whilst this seems nonsensical to me, it is what it is. I would hope over time, as the annual allowance keeps getting cut, that they will drop the stupid LTA. In effect if you get stellar returns from some of your investments (Russian gold miner anyone?!) then through no fault of your own you will get penalised. For me I can really see myself ending up moving money into cash rather than invested so I don’t get penalised. This is insane – why not let me accumulate more as in all likelihood my spending will then go up, so not only will HMRC get more money from direct taxation, but also from VAT, restaurant employees etc. as I spend my hard earned cash
  • Constant Government meddling. Although this budget (March ’17) is one of the first in recent years that has not had a change to the pensions scheme, Mr. Osborne and Mr. Brown have been constantly meddling (ruining!) pensions in their time, and it is highly likely that this will continue in the future. I do have an issue with the government saying it is “losing” money on the tax subsidy for the rich, but in fact the reason the rich get so much back is because they pay so much in tax in the first place. If they do change the tax relief approach, then people risk getting double taxed, so taxed on the way in (similar to an ISA but probably at a slightly lower rate), and taxed on the way out. Talk about discouraging savings!
  • Withdrawals are taxed at the relevant and prevailing tax rates. We have no control over what the future tax rate would be – it could come down (I can dream, right?), it could go up. Tax allowances may change. It is a huge unknown, but at least with the pensions freedom we now have the ability to change how much we withdraw to ensure we minimise the tax hit

 

ISAs

So I really do believe that everyone should have an ISA (I am thinking particularly Stocks and Shares not cash) – the only reason to have a cash ISA at the minute for me is if you can’t afford to fill your S&S ISA and need to keep cash. I am not going to go into the details of an Innovative Finance ISA or Lifetime ISA etc. for the sake of simplicity I am only looking at a standard S&S ISA.

The government seems to be smiling on ISAs with the allowance going shooting up over the years to £20,000 per person per year from the ’17-’18 tax year. This is a huge amount of cash to find for the majority of people to find. If you are a city banker, or a high flyer somewhere then it is easier, but £20k of taxed income is a large amount of cash regardless.

I do believe that this is part of the governments attempt to kill off pensions – they get the tax take up front then and can spend it as they see fit (badly in other words!). My concern is how long it will be before we get limits on how much can go into an ISA or how much can be saved there. Whilst Lord Lee became the first person to be an ISA millionaire, nowadays it is becoming theoretically easier and easier to get there (I say this based on the limit, not on the ability to put that much in!).

I am not an ISA millionaire yet sadly, and I am a some way from it, however I would love to get there so the more money I can put into an ISA the better IMO. If I can hit a million in various ISAs when I come to retire then I will be very happy.

Pro’s

  • Currently unlimited tax free growth – you put money in that’s it. If you get stellar returns and end up with millions in there, great. No capital gains tax, no need to fill in a tax return for it, just keep going. Any dividends can be reinvested without any tax implications as well
  • Withdrawals are tax free, regardless of how much you pull out, and when. Suppose you were an ISA millionaire and you decided to cash the lot in, sell everything and withdraw the lot. £1,000,000 into your current account. The tax bill? £0. This gives the potential for almost unlimited upside. This is just fantastic, and considering you could contribute all your life (from Junior ISA on), even if you only start at 18 or 21 in your first job, slow and steady does the job
  • Currently only positive government meddling (I.e. increasing the limit). It seems that the government is very keen to promote ISAs (at the cost of pensions IMO), although they are starting to make it more and more complicated with FI ISA, LISA, Help to Buy ISA etc. But so far no cuts in what can go in or the growth, now is the time to make the most of it!
  • A pretty reasonable allowance, especially when a couple combine. Whilst not as high currently as the pension contributions the new £20,000 is a large whack of post taxed cash to find – with tax free allowance etc. You would need to earn about £25,000 per year to just fund the ISA alone – that’s assuming your monthly living cost is £0!

Con’s

  • Can be easily accessed, so temptation is always there to dip in. There are no penalties to decide you really need that latest holiday to Ibiza / Walking in Wales / Helping Orphans in Peru (whatever tickles the fancy) which means if things get too much you can harm your long term savings
  • Counts as part of means testing for some benefits. This is a savings vehicle after all, so will count as part of your assets, so for example if you are unemployed, run out of emergency funds, the government will expect you to sell down your ISA before it will give you support
  • Included in your estate should you need to enter debt negotiations (highly unlikely in the FIRE community). No company is going to accept reduced repayment on debt when they can see you have savings, they are going to demand you sell up and repay the debt

So for me, there really isn’t a clear winner between the two, but the importance of the vehicle does vary according to individual circumstances.

When a pension beats an ISA

There are some occasions when it is clear that you should invest in a pension over an ISA. Remember of course that this is my personal view, you need to make your own mind up 🙂

  1. When your employer will match your contributions. You should never turn this down – it is free money. If they match you to 5%, you should put 5% in, as this would give an immediate 100% return. When you are hitting the LTA or over the allowance, then its time to think hard, but I would suspect even with a 55% tax charge you may still be better off taking the hit (I would need to work through the numbers)
  2. When you are around the limit of a Tax or Benefit band. For example if putting an extra £1,000 into a SIPP to avoid paying the 40% tax would be a benefit – after all would you rather have ~£550 in your take home pay (don’t forget the NI charges), or £1,000 in your SIPP?
  3. If you struggle to resist temptation and can’t build up a good pot of retirement funds then the enforced lack of access of a pension will remove this temptation

When an ISA beats a pension

Equally there are times when an ISA would beat a pension

  1. When you need funds in the relative near future (i.e. before 55/57/whatever age the government changes it to) – ease of access being vital
  2. If all your other investments are in pensions – you want some ready investments especially if FIRE is in your sights
  3. When you are at risk of hitting the Life Time Allowance (LTA) in your pensions. £1,000,000 sounds like a scarily big number. Suppose, for ease, your salary is £24,000 and you get a 5% match from your employer, that gives you £200 per month to put in. Do that for 35 years, at 7% return and you will hit £360,000. Make it 45 years and its over £750k! That assumes no pay rises, bonuses, side hustles etc. – not likely if you are thinking about FIRE so this is a real concern
  4. When you have a specific goal in mind, e.g. a wedding or childrens school / university fees and will need the cash

Conclusion

You will notice that I haven’t mentioned Inheritance Tax on this comparison, as this depends on the marriage (or not) and children (or not) situation of each individual, and these will of course change over time.

Despite all of the above, I still don’t believe there is any right answer to this, as it  is down to individual circumstances. For me, it has to be both. I put into my company pension, my personal pension, my ISA and my other half’s ISA. This means I have a spread of companies providing the tax efficient wrappers, and in both our names should the worst happen to me.

In an ideal world, I would like to be able to max out my pension contributions and fill both my and my other half’s ISA. That’s a heck of a lot of money to find but provides a great incentive to really try and maximise my savings. What would I do if I had money left over after that? Pay down the mortgage as much as possible. I will worry about that if I get to that stage!

What do you use – ISA or Pension, or Both? Or do you say to hell with this savings lark, I am going on a luxury world cruise? 🙂

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Oh what a May…. May ’17 income and expenses

I think the title says it all. This month has been simply epic on many sides. Why am I doing this post slightly earlier than normal? Well my pay has gone in, and I restart my calculations on the 28th, and I am not going anywhere today nor spend any more money so I can be 100% confident in the numbers.

Firstly, I should clarify a little on how this months numbers have been reached. Back in March I paid up for all of the ski holiday costs, and took the hit on my savings rate – declaring the expense as “Holiday”. This month, some of the guys transferred the money back to me to pay for their share. Normally I would just shove this into savings or off the mortgage and not count it (I already took the “hit” back in March) however this month it all got spent. Ok not in the same category, but still spent. On entertainment. Ok, mostly alcohol!

I’ll be honest, it was GREAT fun! Yes folks that’s right – I spent money and I enjoyed it. I won’t be doing it again at that rate for a while that’s for sure. Would it have knocked maybe a month of my retirement date? Quite possibly, but it is the journey as much and I wouldn’t change the experiences I had this month.

I am sure some may say that this makes my numbers wrong as I have not counted this extra income, but for me that would be double counting – so it stays as it is, if you don’t like it, tough – go and pour yourself a drink and mellow out 🙂

So what was it I got up to this month that caused my spending to get out of control? I will make you read through and see before you get to the numbers (unless of course you quickly scroll through the next bit!).

Rugby

So the month started out as it was clearly going to go on. Down to Twickenham for a rugby match – the 100th Army vs. Navy. I knew this was going to be a heavy one (it usually is!) and this proved to be the case. Trust the British to be in the pub before 10am and drinking. We got there a bit after 10am, and the queue to the bar was already about 3 deep and it felt like 10pm on a Friday night it was so busy. After a few drinks in the pub, we headed off to Twickenham to erm… drink more. We got to see the rugby whilst…. still drinking (I love the fact you can still take beer in!). At half time Prince Harry was there to talk abut the Invictus games (a great thing IMO) which was fun and I really do take my hat off to those guys. After the match… yup you guessed it, back to drinking! Heading back into town after the game and the beer serving stopped… to a pub of course.

Unfortunately we stayed in the pub a little too long which meant we missed the last train home which added to the expense with a taxi back.

Most definitely not an FI day but a great day. You could easily do it cheaper without drinking so much but it was fun, and I don’t regret a penny of it. This was all paid for out of the holiday funds that were transferred in.

Learning a new skill

So one of the additional unexpected costs this month was needing have a tuxedo. Wait – what?! Yup, I needed a tuxedo as we were invited to the World Premier of a film this month – red carpet, celebrities (apparently, I didn’t recognise any, but then I wouldn’t!) and all that gubbins. I actually ended up buying one rather than renting as the cost wasn’t that much more and means I now have one for other events (it’s not the first time I needed one). I bought both a self tie and a pre-tied bow tie, and decided at my age it was time I learnt how to tie my own bow tie – which I can happily say I can now do.

The film itself was great, in fact the whole experience was great. The after party was held in a club which of course meant drinks were expensive once the free bar finished.  Add in a taxi there and back (we were both dressed to the 9’s as it were) made it an expensive evening out but great fun. Again this was all funded out of the holiday money!

New recipes

I also tried out 8 new recipes this month – mexican dishes, chinese dishes, thai dishes a real variety. Some of them I really liked and will make again, some I won’t bother with – but that is part of the fun! The great side of this is that it wasn’t that expensive, and was actually fairly healthy with lots of veg as well.

Majestic had a special offer…

Ooops. I knew it was a bad idea to go to the local Majestic – a very dangerous place! I didn’t *need* to restock as I still have plenty of wine in, but…. well. Yes. 25% off Champagne and 10% off all wine. Now I was at least reasonably restrained on the Champagne but it is always good to have some in for emergency 🙂 The wine I admit I probably got a little carried away with, but the money from the ski trip helps make this look not quite as bad as it really was! Again, a large chunk of this came out of the holiday funds.

Other bits

There were also a few days and evenings out which added to the expense of May, which is why I find myself typing this (helped by a glass of wine) and feeling absolutely shattered – maybe the wine last night at the FI London meetup in the park slowed me down a little?

The extra cash from the holiday money also covered this quarters big shop, as well as a meal and other drinks out.

Income

So as always I had my steady salary drop into my bank account, always nice, and it’s stabalising at a higher amount now that I have finished paying a previous years tax back.  I don’t include any of my personal ISA dividends in my income statement, that is just part of the growth of those portfolios. The income thrown off by my other half is included, however this is an incredibly small amount at present (less than 1% of income) so it is more of a statistical error! Having said that, her ISA threw out it’s highest ever amount, and a huge increase on last year  which is great, it’s starting to get close to being a significant benefit now. Needless to say this is going straight off the mortgage!

So, steady as she goes on income – very slowly creeping up but for the first time it feels like I am really making progress.

Expenses

Ok, so it was an expensive month. A very expensive month. With the exception of last November, probably the most expensive month I have had since starting this blog. The only reason I was able to keep the Go T’ Pub ISA at the full £1,100 was the fact that I got the holiday cash back, I raided my Cash Flow Fund, and I have even borrowed a little from June’s savings funds. I need to be very careful in June. I know Rory from UK Doctor On Fire (and I am sure others) was keen to know the actual numbers, however I am not willing to share them in public. For now, you will have to continue to put up with just the percentages but hopefully that will still help people!

Item Notes Amount
Things I choose not to avoid* Mortgage, Insurance, shared bills etc. – yes, we could move somewhere cheaper, not have insurance, reduce our bills a bit and so on, but we are where we are. 41%
Groceries All the food and other stuff needed for home 2%
Alcohol for home Home alcohol consumption only 9%
Bicycles / Car related Any costs related to either the bikes or the car 0%
Alcohol Out Generally, its the pub…. 2%
Eating Out I include purchased lunches in this as well as meals out etc. 4%
Other My catch all for anything I may have missed…. 2%
Holidays Any spending related to holidays, flights etc. 0%
Savings Anything left over! This includes money into ISAs, mortgage payments and non relief pension contributions. My company pension comes out before it hits my bank account so isn’t included, nor do I include the “top up” of money when my money goes into my personal pension (i.e. I put in £100, I register it as £100, not the £125 that gets credited in my pension) 40%

The “Stuff I do nothing about” category is down 1% due to my new income and slightly lower travel costs this month with a couple of bank holidays – lets see if it stays that way next month.

My savings rate is actually just under 40% – it is the rounding that makes it 40%, so I would declare me as meeting my goal, but not my stretch. Had I not received the cash for the holiday then this would have made life very interesting given the expenses – I would have had to raid my Rainy Day Fund.

It does give me a real hope that I can potentially get up to 45% savings rate on a quiet month (I think I do have those from time to time!), and fills me with confidence for the year(s) ahead.

How was your May? Have you been enjoying the weather and making the most of life?

* This covers a number of things that I would class as essential for me. Yes, I could move to somewhere cheaper to reduce the mortgage (which in turn would reduce the insurance I have to pay), yes I could reduce my bills by switching energy supplier etc. but it comes down to what I am happy with. There are a few other things in there that are classified as essential that others may object, and so I have just lumped it into there.

How much of an Emergency Fund should you have

So now you know how my Emergency Fund is structured, I thought I would do the customary post on how much you should have in it!

There is always a lot of talk about how you should have an Emergency Fund, and then how much should you have in there. The normal guidance is 3 – 6 months living expenses in case anything comes up. I tend to flip around quite a lot on this – at one point I have held virtually no emergency funds (as things came up), and slowly built back up. Right now, if I take just cash and cash equivalents, I have just over 3 months of income available to me (having put half of my cash ISA into CTY). I chose income rather than expenses, as I want to make sure I can still fire off my regular savings investments, and to date the only time I have needed to go into my true emergency fund is when I have taken time off between jobs (it has been up to 3 months) so I always question the validity of this. If I was FIRE then I would probably maintain some form of emergency fund to balance out downturns (likely a year or two’s worth), but right now too much cash seems a waste.

I am experimenting with the Go T’ Pub ISA to see how long I need to keep my emergency cash in the stock market before it becomes a no brainer. Given the returns on cash are so low, automatic reinvestment of dividends from an IT should allow it to grow faster, and I need to be prepared for an up to 50% drop in the price and still be able to sell it. Under no circumstances should you consider this without doing enough suitable research, planning etc. This is most definitely not a recommendation for you!

In essence it comes down to how you want to play it. If you earn £10,000 a month (I wish!) and only spend £2,000 a month you probably don’t need much of one, but if you earn £2,100 a month and spend the same £2,000 a month I would suggest you build one, fairly fast! I take the view that I can cope with “small” emergencies quite easily (e.g. an unexpected car repair bill or boiler repair etc.) on the day to day approach, although that means going into the Cash Flow Fund.

Recently I have found myself questioning what would I need the emergency fund for, exactly. Yes an emergency, but that is a rather flippant comment. What is an emergency that I can’t cover normally. Losing your job is the obvious one, so not living pay cheque to pay cheque will help, and you will need some cash, but how fast realistically can you start work in some form again, be it an Uber drive, shelf stacker or another company in the same career (or even freelance).

I am lucky in that I get paid in arrears (so for the work I do in say April, I get paid at the end of April), and that pays for the next month’s expenses (so May) so I am in a strong cash flow from that point of view, or a bad one that I still need to work! I have yet to lose a job, I have always quit on my terms, so I have been able to build up cash so it didn’t come as a surprise.

I’ve held several parts of my emergency cash for years, and never needed it (granted at one point I did use my overdraft for a month or two).

Why am I moving some of my emergency cash into stock? Well, I want my money to work hard for me. Each £10 a month the portfolio generates, that’s £60 less I need to save into the emergency fund. It’s going to be an interesting experiment, and will take a good 3 or 4 years before it bears any real fruit, and it certainly isn’t for most people, but I work on the principle that I can cover most emergencies as is. Even when we moved home, I only used on fraction of my emergency cash even then – my cash ISA didn’t get touched.

That said – the comfort of knowing I can last a few months, continuing to invest, without a thought is a comfort, although taking money out of premium bonds or a cash ISA would be hard for me… but each to their own!

I certainly wouldn’t be happy with less than 1 or 2 months cash readily available but I don’t feel the need for much more than 3 months whilst I am in accumulation phase – the more that I can get into investments, the better!

How much do you keep in your emergency fund?