Series 2 Episode 04 – Investing for Beginners; Pensions VS ISAs
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Series 2 of the podcast is all about breaking things down and unmasking the basics of investing for beginners. With that in mind, in this episode I’m going to talk about some of the different ways you can get your investments to work extra-hard for you. Simply by making smart decisions about where you keep them.
Now once you’ve made the decision to invest and you’ve got an idea of what you want to buy, the next thing to look at is where you’re going to keep it.
And this is important for two reasons;
1. You need to be able to access your investment in a way that suits you.
And this depends on your goals. What are you investing for?
Do you need to be able to get to your money quickly, or doesn’t that matter?
2. Tax (Stick with me, this is interesting!)
The tax you’ll pay on your investment, and when you’ll pay it, depends on where that investment is. And you can make some significant tax savings depending on where you choose.
Think of investments as being like any other product. When you buy something, whether it’s a laptop, a new dress or some shoes, you have to think about the best way to store it.
If you store something properly, it’s more likely to do a better job for longer. In other words, you’ll get more out of it.
You may have heard of different types of investment products – like ISAs (Individual Savings Accounts) pensions and funds – and been completely baffled by what they are, and how they’re different.
To keep it simple, I like think of them as being like different storage solutions for your investments. In other words, where you put your money.
If we go back to access and tax, that’s pretty much what the differences boil down to between ISA’s and pensions.
In fact, products like pensions and ISAs are often called ‘tax wrappers’ because the way they ‘wrap up’ – or store – our investments, influences the tax you pay. And they have different rules around getting your hands on your money.
I’m going to use my trusty shoe analogy to explain the features of the main product types, so hopefully you’ll start to see when you may or may not want to use them for your own investments.
Investing for Beginners; Pensions
First, I want to cover pensions. Anyone employed by a company – in other words people who aren’t self-employed – will probably have a pension through work under auto-enrolment. You will have seen an increase this April in the amount of contribution. And if you’re self-employed, you may have, or thought about having a personal pension.
Lots of people don’t realise a pension is a way to invest, especially if it’s all been arranged through work and you’ve had nothing much to do with it.
But that’s exactly what it is.
You make a payment, usually monthly or yearly or whenever you have money available, and it goes into the fund or funds that you or your employer have chosen. And these funds sit inside the pension.
The pension, essentially, is a storage solution for that money. And a pension is one of the most tax efficient ways to invest.
‘Pension’ is actually one of my least favourite word simply because of the image in conjures in people’s minds. When we think of pensions, we think of something for our old age, and probably something we don’t really need to worry about yet. If you think of a pension being like a bucket of money, that changes the meaning of the word ‘pension’. We’re able to see for what it is; investing for your future self.
When you pay money in, the government gives you something called tax relief, which is based on your income tax rate.
I like to call it free money!
In other words, if you pay 20% income tax, and you want to invest £100 into a pension, it only actually costs you £80 because the government stumps up £20, and pays it directly into your investment.
When a fund is inside a pension, you also don’t pay any tax on the money you make, or in other words, the investment growth.
It may come as a shock that the tax man would penalise you at all for investing, but the reality is, there are tax implications for any type of investment. With a pension, the only tax you pay is when you take money out of the investment. And that’s just at your normal income tax rate.
So, pensions are great for saving on tax, but what about access?
Well, pensions have been designed specifically to encourage us to invest for the long term. Once you’ve paid money in you can’t get at it until you’re at least 55 in most cases.
This may seem harsh, but when you think about it, pensions are designed to help us build up enough money to have an income when we retire. So, the fact they protect us from being tempted to take money out too soon, and they give us the opportunity to benefit from long term investment growth is actually really positive.
Historically this was not the case, but these days we do have a choice about how we draw on our pensions, or take the money out of the investment. It used to be the case that at retirement, you would take your bucket of money to a pension provider and based on your age and health they would agree a fixed income to provide you with until you died.
Today, it’s still perfectly possible to follow this route. But there are also other choices you can make with your pension pot. And this allows you to make the right choice based on your own individual circumstances and the plans you have for your money.
I think of pensions as being for your money exactly like a sturdy box for your shoes.
If you’ve invested in a really precious pair of shoes for special occasions, you don’t want to have them kicking around on the wardrobe floor. You probably have them carefully wrapped in tissue paper and stored in their box on a shelf.
It may be a pain to get to them, but you know they’re in mint condition, they’ll last for ages and you’ve probably got the absolute most out of your original purchase.
So, if your goal is saving for retirement and you know you don’t need quick and easy access to your money, then a pension is a great way to invest.
Investing for Beginners; ISAs
And you may have seen lots of adverts for different ISAs in the run up to 6 April each year. That’s because there are rules around how much you can invest in an ISA each year – and the tax year runs from the 6 April.
So, we’re often encouraged to put as much money as we can, up to the limit, into an ISA before the year is up. There are limits for pensions too, but they’re much higher and most people don’t have to worry about going over them.
So why would you choose an ISA as your storage solution?
Well, like pensions, you can use them to invest in lots of different funds and get tax breaks. The tax breaks are different though. With ISAs unfortunately, the government doesn’t give you tax relief on what you pay in,so there’s no free money on offer. But, like pensions, you don’t pay tax on any investment growth. What’s more, with ISAs, you don’t pay income tax when you take money out.
They’re also really easy to access – unlike pensions!
So, this combination of tax breaks and being able to get at your money anytime, makes them a popular option for investors who are maybe looking for a short to medium term investment. Or people who don’t want to tie all their money up until they’re 55.
But remember, the same principle applies to investments in an ISA as to any other investment and that is, the longer you leave your money invested, the better your chances of growth are.
Back to our storage analogy, and I like to think of ISAs like one of those drawstring bags you often get for shoes. Especially if you buy shoes online. They’re a great option for shoes you want to look after, but probably not for those special occasion shoes.
The bag is much easier to get in to than the shoe box on the shelf. And it still protects your shoes from getting dusty or scratched. But, it’s not as sturdy, so your shoes are more likely to get damaged, and may not last as long.
Investing for Beginners; Without a ‘wrapper’
Finally, I want to look at funds as a product in their own right. So yes, you can invest in funds inside a pension or an ISA and get those tax breaks I talked about, but you can also invest in them on their own.
This is often called investing in ‘unwrapped’ funds because they’re not inside a tax wrapper so, crucially, they don’t have the tax advantages.
I’ve talked before about funds being a ‘collective investment’, In other words, lots of people put their money in together. So, when you invest, you don’t buy a whole fund, you buy part of one.
Again, there’s lots of different terminology and jargon around collective investments. Stuff like unit trusts, open ended investment companies (nicely abbreviated to OIECs), exchange traded funds (ETFs), and investment trusts.
I really don’t want you to worry about all this. The main differences come down to legal structures.
But to us, as investors, they look and feel pretty much the same.
So why would you invest in a fund that sits outside a pension or ISA?
Well again, it all comes down to what you’re doing it for. What’s your goal?
For example, it wouldn’t make any sense to have saving for retirement as your goal and not use a pension for at least a good chunk of it. For all the reasons we’ve talked about.
But, you might want the flexibility to build your own portfolio with some of your money, and pick and choose specific funds – because sometimes a particular pension or ISA product doesn’t offer the ones you want.
The funds could also be cheaper unwrapped, because you’re not paying for the pension or ISA product. And they’re also super-easy to access, so you can get to your money quickly.
Having said that, you’d be pretty unlikely to put all of your money into unwrapped funds, because you wouldn’t get any of the tax breaks. Remember how I said that with pensions and ISAs you don’t pay tax on your investment growth?
Well, in unwrapped funds you do.
It’s called capital gains tax (CGT). You’re allowed a certain amount of gain tax-free, but after that, you’re taxed on any profit you make. It’s important to know though, that you only pay tax if you take your money. You don’t pay any tax on growth when your money is still invested.
Looking again at the storage analogy, unwrapped funds are like having all your shoes on the floor of the wardrobe. It’s dead quick to open the door and get your hands on the pair you want. But it’s not a great way to preserve your shoes. They’ll definitely get dusty, and most likely squashed or scratched.
This is the worst-case storage scenario when it comes to protecting shelf-life and value.
The main point I’m making with all of this, is like a pair of shoes, a fund is the same fund whether it’s unwrapped, inside an ISA or inside a pension. But your experience with that fund will be different. Depending on where it is, it’ll be easier or more difficult to get your hands on your money. And depending on the storage solution – or product – you choose, you’ll be more or less protected from paying tax.
Remember, any financial advantage can have quite an impact on your personal financial well-being – especially over the long term. Consciously making these decisions to invest in yourself is such a powerful thing.
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