Of course, it depends. Pension saving is currently more tax efficient than ISA saving, due to the fact that some of the pension saving can be taken as a tax free lump sum. Also, pension saving may get further tax advantages if it is done via salary exchange/salary sacrifice.
However, the downside is that pension saving cannot be accessed until age 55 at the earliest (unless you are in very serious ill health with less than 12 months to live). Therefore, pension saving needs to be with money you do not need to have quick access to.
ISA saving is still a tax efficient form of saving, and brings with it the flexibility of near immediate access.
So if you might need your money well before age 55 (eg for a house deposit, wedding, car, holiday etc), then ISA saving may be the better option, even though it is slightly less tax efficient than pension saving.
You can generally save more into a pension each tax year than and ISA, although the 2018/19 ISA limit is currently £20,000 per year per adult, so for most people this limit is not an issue.
|ISA saving might be more appropriate if:||Pension saving might be more appropriate if:|
|You might need your money before age 55||You don't need your money back until after age 55|
|You have more than £20,000 to save each year|
Generally speaking, you should start from the position that this is not a good idea, and then see if there are any special reasons why this might not be the case.
Special reasons which might lead you to consider a transfer from an old DB scheme might include:
- You are single and have no intention of marrying before you die
- You are married but do not wish to provide a pension to your spouse on your death
- You are in poor health or have a significant chance of developing an illness that will materially reduce your life expectancy
- You have concerns over the sponsoring employer’s long term viability and your expected pension benefits exceed £30,000 pa
- You need access to more money in the short term and are willing to accept the risk that your pension benefits may be lower in the longer term
In any situation, you will be required to seek independent financial advice.
This comes down to the several things:
- The rate you are paying on your mortgage (the higher the rate the greater the incentive to pay it down)
- Whether you have any other debt with a higher interest rate (APR) than your mortgage, in which case pay down the higher APR debt first
- Whether you might need the money back at short notice (OK if you have sophisticated mortgage such as offset, or flexible arrangement that allows you to re-borrow without material charges)
- What other investments are available?
- For example, are you maximising your employer’s contributions to your pension – if not, then this might be the place to start
- Your employer might offer share schemes, in which case find out about these as well
This depends on various factors:
- Your timescales – if quite short (eg saving for a car, a deposit, a wedding, a holiday), then this is probably not a long enough timeframe to allow the volatility in shares prices to work in your favour.
- Even if you a have a longer time horizon – eg 5 years or more, whether you are willing to accept the risk that your investment might go down from time to time.
- History shows that over long periods, shares generally do better than cash, although this is by no means guaranteed. So to choose shares you need to have a long term view and still be willing to accept the risk that your investments may be worth less than you paid in from time to time.
Share schemes are generally good opportunities as they come with special terms available only to employees of the company. However, not all shares schemes are the same and you need to consider various factors such as:
- Do I plan to work for this company for a good few years (most share schemes have conditions such that the special terms only apply after a minimum period of holding the shares and still being employed). But bear in mind most people end up working for companies for far longer than they intend when they first join.
- If you leave before the special terms apply, then you might get back less than you put in if the share price of the company has not done so well whilst you invested in the share scheme.
- Even if you stay for years and qualify for all the special terms, you can still get back less than you put in if the share price fares particularly poorly just before you cash in.
- These are single company investments which are generally not recommended for inexperienced investors. Whilst the special terms give added protection, and there is a maximum you can invest in each month, there is a chance you can still lose some money.
What is salary sacrifice?
Salary sacrifice is a tax-efficient way for you to make pension contributions. In essence you agree to give up part of your salary which your employer will then pay into your pension as a pension contribution.
As you are effectively earning a lower salary you will pay less tax and both you and your employer will pay lower National Insurance Contributions. You may therefore see an increase in your take home pay compared to if you made the same pension contributions but not via salary sacrifice. The employer may also pay a part or all of their National Insurance contribution saving to your pension in the form of further contributions but there is no requirement for them to do this.
Are there any drawbacks/limitations?
You can't use salary sacrifice if it would reduce your earnings below the minimum wage
If your employer is providing you with life cover, this may be based on a multiple of your salary so the level of cover may fall if you use salary sacrifice.
You won't receive a refund of contributions if you leave employment within 2 years. This is because you have not directly made any contributions so there are none to be refunded.
You should consider how a lower salary will affect the amount of money you are able to borrow for a mortgage.
Your entitlement to certain State benefits may be affected if your salary falls below the level at which you pay National Insurance Contributions. Your employer should be able to confirm if you are affected in this way.
Most companies that offer salary sacrifice also issue Q&As which give guidance on how you will be affected, or offer a calculator for you to check.
Is salary sacrifice a con?
No. Many employers in the UK operate this type of scheme.
Whilst a reduction in National Insurance Contributions for you and your employer means a lower overall tax recovery for HMRC, HMRC has made it clear that these schemes are fully legitimate.
Of course, HMRC may change its view in future, but until that happens pension salary exchange is typically a win-win for employees and employers.
There are currently two parts the State pension:
- The Basic State Pension
- The State Second Pension
The maximum Basic State Pension is currently £6,549.40 a year for a single person.
To get the maximum you need to have 30 qualifying years. A qualifying year is when you have earned enough to pay national insurance. Whilst the level changes each year, currently this means earnings in today’s terms of £6,032 a year.
The State Second Pension depends on various factors such as earnings and employment status. You automatically build up some State Second Pension each year except for years where
- You are self employed
- You were “contracted-out” of the State Second pension scheme
- You were a member of your employer’s scheme and paid lower national insurance contributions (often referred to as a contracted-out scheme)
- You personally chose to contract-out of the State Second Pension (in which case you should have built up a pension pot of your own, probably with an insurance company)
From April 2016, the two parts of the State Pension are being combined. Under the single State pension, the maximum state pension is £8,546. However, to get this you will now need to have 35 qualifying years although it will not matter whether you are employed or self-employed, provided you earn enough each year to pay national insurance.
Even if you have 35 qualifying years when you reach your State Pension Age, if prior to 2016 you were “contracted-out”, your single State pension will be reduced. Whilst the exact formula is yet to be published, it is unlikely that your Single State Pension will be any less than what you have built up under the Basic State pension and State Second Pension as at April 2016.
To find out how much State pension you have already built up based on qualifying years to date, complete a BR19 form online and HMRC will write to you to confirm your State benefits.
The tax bands in the UK change each 6 April, but based on bands for the 2018/19 tax year, you will need to have income in excess of £46,350 to pay any higher rate tax.
Currently, your personal allowance (earnings on which you pay no income tax) is £11,850 unless you earn over £100,000, in which case things get a bit more complicated. Let’s assume you earn less than £100,000.
The next £34,500 of earnings is taxed at 20% (known as basic rate tax), so when added to your personal allowance, you can see why you can earn up to £46,350 before paying higher rate tax.
Earnings above £46,350 will be taxed at 40% (known as higher rate tax).
Earnings above £100,000 and up to £120,000 impact on your personal allowance so things start to get complicated.
Finally, earnings above £150,000 will be taxed at 45% (known as additional rate tax).
There are lots of calculators available on the web – click here for an example.
For tax purposes, your income is added up each tax year and then split into bands. Building on 'Am I a higher rate taxpayer?' question above, the bands are:
Personal allowance (0% tax): £0 to £11,850 (assuming you earn less than £100,000)
Basic rate (20% tax): £11,851 to £46,350
Higher rate tax (40%): £46,351 to £100,000
If you earn above £100,000, well, it gets complicated as your personal allowance is reduced by £0.50 for every £1 earned between £100,000 and £120,000. So let’s assume you earn less than £100,000.
Now, your marginal rate of tax is the rate of tax that applies to you if were to earn £1.
So if you currently earn £30,000, if you were to earn £30,001 (ie £1 more), that extra £1 would be taxed at 20% - so your marginal tax rate would be 20% (or basic rate).
If you earn £50,000, if you were to earn £50,001 (ie £1 more), that extra £1 would be taxed at 40% - so your marginal tax rate would be 40% (or higher rate).
If your extra earnings (eg from a pay rise or a bonus) moves you from one tax band to a higher tax band, then the higher tax band only applies to the earnings that fall into that tax band. For example, say your annual salary is £40,000. You are a basic rate taxpayer and your marginal tax rate is 20% (since earning £40,001) would mean the extra £1 is taxed at 20%.
If you received a bonus of £7,000, some will be taxed at basic rate and some at higher rate because the £7,000 when added to your £40,000 takes you into the higher rate tax band. In this case the bonus up to £6,350 (taking your earnings to £46,350) will be taxed at 20% and the balance (£7,000 less £6,350) will be taxed at 40%.