I don’t know about you but breakfast in my home is always somewhat of a chaotic affair. There’s the stress of getting teenage kids up and out for school, with emails piling up on my phone and the usual rush to get off to work on time.
Sat around the breakfast table the other day, whilst working through the day’s mail, I opened up a bank statement and was reminded of how little interest it’s possible to earn cash savings these days.
And I’ve got to admit that my disappointment quickly turned to frustration as I noted that, with inflation starting to pick up, my money might not even be worth as much in real terms in a year’s time.
Now it’s important to have quick and ready access to a certain amount of cash so it’s never going to be the case that you or I can avoid low savings rates altogether. But how can you get the most from your savings?
You know what… It’s easier than you think. If you’re a higher rate taxpayer it’s possible to boost your savings by 67% overnight. But you’ll have to be quick because your opportunity to use this year’s tax allowances closes at midnight on 5 April.
Let me show you how it works.
Why interest rates are at a historic low
Never have interest rates been so low, and for so long. It’s hard to believe that in 1990, fewer than 30 years ago, the Bank of England base rate reached an eye-watering 15%. Ten years earlier, it was even higher as rates stretched to 17%.
So what’s changed? There are three reasons why interest rates have fallen:
- Governments in most developed countries have been more disciplined in the management of their respective economies. There’s a real desire to avoid the boom and bust cycle.
- Inflation expectations in the medium to long-term are low. This is because our aging population and shrinking workforce has reduced long-term growth in demand for companies’ products and service. That in turn limits any incentive for them to increase prices. Note this is quite different from the short term impact of Sterling’s devaluation post-Brexit. The impact here will only be temporary as higher import prices work their way through the system.
- The quantitative easing programmes launched by the UK and many other central banks has involved the government buying back huge swathes of it’s issued bonds. The latest round of QE announced by the Bank of England on 15 December 2016 will involve the purchase of some £435bn of its bonds. In addition other banks have been forced by regulators to rebalance their portfolios in favour of high-quality government debt.
Together these have increased demand for bonds (pushing up their prices) and reducing inflation and therefore interest rates.Judging by the prices for 10-year government debt, the markets do not currently perceive there to be a substantial risk of inflation rising. On this basis, the savings rates are unlikely to recover in a dramatic fashion any time soon.
How tax relief on pension contributions can boost your investment
If you can afford to wait until age 55 to access your money, you might want to consider levering the tax relief on pension contributions to give your savings an immediate and very substantial return.
HMRC does not consider your pension contributions as income for tax purposes and you’ll not need to pay any tax on any money you save into your pension. Because you get the tax back, HMRC are basically providing a free contribution to your pension. And those savings can be considerable, very considerable.
Higher rate taxpayers stand to benefit the most
If you’re a higher rate tax payer you’ll get 40 pence back for every 60 pence you save into your pension. That’s a healthy 67% return and very different to returns on cash savings!
How the HMRC gives you that money depends on how you’re paying into your pension:
Anyone who hasn’t maxed out their employer’s pension contribution should do so as this will give you a double whammy; getting extra money both from the taxman and also your employer.
In this case, your contributions including tax relief will go straight into your pension pot.
Money doesn't need to go into your employer's pension
If you’ve already got all the pension benefits that your employer is willing to give, you might want to consider setting up a private pension instead. This will give you total control over your investments so that you can be sure you’re making your investment work as hard as possible.
In this scenario you’d be paying into your pension from your net earnings and the relief is applied in a slightly different way. Your pension provider will apply your basic rate relief straight away. So for every 80 pence paid into your private pension, your pension account will be credited another 20 pence immediately.
However, you’ll also be claim back an additional 20% from HMRC through your annual tax return. Assuming you don’t have any other tax liabilities to pay, you’ll get this extra back as cash at the end of the tax year.
A different route, but again a £1 contribution to your pension will only cost you 60 pence.
Using up the annual allowance your given could be worth an extra £68,000
Most people pay into their pension through the PAYE system, where an employer deducts contributions at source. But you can save more money into your pension if you want, either into your employer’s scheme or separately into a private pension.
Doing so allows you to grab even more money back from the HMRC. You can do this at any time although there is a limit on how much you can invest. This is called the Annual Allowance.
Annual allowance rules
You’re annual allowance depends on your circumstances. The rules are nuanced but in headline terms:
You can pay in up to £40,000 a year (including tax relief at 20% if not provided at source) or 100% of your salary, whichever is the lower;
If you are already taking benefit from a defined contribution pension scheme, the allowance is reduced to £10,000 or 100% of your salary (Note: this allowance is reducing to £4,000 from 6 April 2017, so if this applies to you it’s important to think seriously about topping up your pension now);
If you’re not paying tax, you can still pay £2,880 into your pension and still get £720 from the tax man to top up your pension by £3,600.
A taper will reduce your annual allowance by £1 for every £2 in earnings you have in excess of £150,000 pa.
The really neat thing is that you can carry forward your un-used annual allowance for up to three years. Thus, for the tax year ending 5 April 2017, anyone who hasn’t been in the habit of contributing to a pension could use the following allowances:
Tax Year Ending
5 April 2014
5 April 2015
5 April 2016
5 April 2017
Do you have a lump sum to invest?
If you’ve recently received an inheritance or have a number of old, poorly performing PIPs or ISAs, contributing £136,000 into a private pension would give you a top up from the taxman (at 20% rate) to your maximum contribution to £170,000. You would also receive a cash refund of £34,000 through your tax return.
In other words, you would have turned £102,000 into £170,000 – a £68,000 immediate gain.
Of course, to contribute at this maximum level you would still need to have earned £170,000 in this tax year to keep your contributions within the 100% of income rule.
It’s not just cash that you should consider moving into your pension
Let me just say that before making any investment decisions you should take independent advice.
That said, you should definitely consider moving any cash that you’ve got held in savings accounts into your pension. The returns on these accounts are likely to be derisory and will certainly be a fraction of the return available from your pension (even if you hold this money as cash in your pension).
Your adviser will help you decide how much money you need to keep outside of your pension, but anything you can wait until age 55 to access should really be in a pension.
And it’s not just cash held in a savings account that you should consider moving into your pension. Moving any cash or equities held in ISAs can also benefit from the tax relief on pension contributions. The returns provided by your tax relief are just as impressive.
Be Careful of Breaching Your Lifetime Allowance
So to recap…If you’re a higher rate taxpayer, you can get an immediate (and guaranteed) 67% return on your investment by moving any cash savings or ISA investments into your pension. You should certainly be mindful to use up your annual allowance before the deadline of 5th April and should remember to carry forward any unused allowance from the previous three tax years.
If you’ve already maxed out your employer’s contributions consider setting up a private pension that you can manage how you like.
Be mindful that pensions lock your money away until age 55 and also be careful not to invest so much that your pension will grow to exceed the Lifetime Allowance by the time you start drawing an income from your pension. This would result in a punitive tax charge being levied and be warned that the sums involved here can get eye-watering very quickly.
If you want to find out more about the Lifetime Allowance, download our fact sheet.
If you’ve got money in your bank account, ISAs or company that you’d like to move into a pension to benefit from this tax break, call us on 0800 989 0029 to arrange a free introductory call. There’s no cost and no commitment.