Use an Isa to boost your retirement fund
This is why many people use individual savings accounts (Isas) alongside pensions when looking to build funds for income in retirement. Money can be drawn out of an Isa at any age so you could dip into your Isa to pay for the trip of a lifetime, a new car or a conservatory, for example.
There are other advantages of Isas in relation to retirement too.
While pension contributions get upfront tax relief, only the first 25% can be withdrawn tax free in retirement – the rest is subject to income tax. Isas on the other hand have no upfront tax relief but the income and capital can be drawn free of tax. In fact, you don’t have to put Isa withdrawals on your annual tax return.
Once you are drawing from your pension pot, taking too much at a time could bump you into a higher tax band. There is therefore an argument for drawing income from your Isa at this time: if you use Isa holdings for income, you don't pay tax on withdrawals and moreover you can leave your pension to grow for longer.
Indeed, this is where pensions and Isas really complement each other. If you have both vehicles in retirement, it makes sense to keep pension income under the higher-rate tax threshold, and then turn to your Isa - maybe drawing capital as well as income to boost your cash flow while avoiding the higher rate tax bracket. If you have lower income in retirement, you could use the same method to avoid basic-rate tax on your income.
In addition, pensions are an effective way to pass your wealth on to your next of kin, so it's sensible to conserve them where possible and use your Isas first. Although Isas can be passed on tax-free to your spouse, they will otherwise count as part of your estate, with any balance above the £325,000 estate threshold (£650,000 for couples) liable for inheritance tax at 40%. There is a way to make your Isa free of inheritance tax, but it involves investing your Isa in the shares of companies listed on the Alternative Investment Market, which many consider to be very high risk.
Pension funds, in contrast – whether or not you have drawn from them – can be left to your heirs tax-free if you die before the age of 75. If you die after 75, income from the pension pot will be subject to tax at the beneficiary's marginal rate, and lump sums taxed at 45%.
If you’re investing to generate retirement income from an Isa, investments to consider include:
UK Equity Income Funds
These invest in companies listed on the London Stock Exchange, which pay dividends to their shareholders. They offer investors a regular income alongside the potential for capital growth.
Global Equity Income Funds
These also offer investors a regular income alongside the potential for capital growth. But they invest in companies from all around the world.
If you’re investing for income you should have a portion of your portfolio in bond funds. This can lower the risk of your portfolio by diversifying away from shares investments.
Bonds are essentially loans to governments or companies and they are also known as ‘fixed income’, because they repay a fixed level of interest to investors over a set period.
There are lots of different types of bond funds, each giving exposure to different types of bonds:
- Government bonds are loans to governments (also called ‘gilts’).
- Investment-grade corporate bonds are loans to big companies that have good credit scores, which means they are more likely to repay the debt.
- High yield bonds are loans to companies that have lower credit scores, which means that they might be more likely to default on the loan and not pay it back.
If you want diversified exposure to fixed income, consider a fund from the Investment Association’s Strategic Bond sector. These funds are able to invest in a wide variety of government, investment- grade corporate and high yield bonds. For investment fund recommendations visit Moneywise’s First 50 Funds for beginners.
- This article is part of our A guide to stocks and shares Isas series.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Alternative Investment Market
AIM is the London Stock Exchange’s international market for smaller companies. Since its launch in 1995, 2,200 companies have raised almost £24 billion listing on AIM. The market has a more flexible regulatory system than the main market and can offer tax advantages to investors but its constituents are a riskier investment than bigger companies listed on the main market.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.