I thought I'd have a first attempt at explaining the UK investment order, at least as I see it. The UK tax system is complex and regularly gets tinkered with by the government but has some powerful saving vehicles available to the discerning Mustachian. The main ones are:
- Pension: The government currently tops up these contributions to make them tax-free, making this the most powerful form of savings. Bear in mind that it's a frequent political debate to reduce the tax relief for higher earners so if you are in this bracket try and make the most of the tax relief now.
- ISA: You can currently save £20,000 per year tax free into an ISA per individual.
- Lifetime ISA: This is £4,000 of your total £20,000 per year ISA allowance, but the government will add 25% (so up to £1,000) of anything saved in a Lifetime ISA
- State pension: The eligibility date of this will change based on your age as it keeps increasing, but assuming you have made National Insurance contributions (essentially a form of tax) for a long enough period, you'll eventually get this too.
Of course these come with significant strings attached, the most important ones which are as follows:
Pension- You cannot access a private pension before a certain date. At the moment this is 55, but it is meant to be 10 years below state pension age, so it's anticipated that this will raise to 57 or 58 depending on when the government gets around to updating it.
- Tax is charged at your marginal rate when you withdraw from a pension. It's still a great deal as the assumption is you will be in a lower income tax band in retirement than you were in your working career and your money has grown tax-free over your career.
- Your pension has a tax-free allowance of 25%, so you can withdraw up to 25% of your pension as tax-free cash.
- The UK has introduced auto-enrollment for pensions, designed to mitigate against a savings crisis as before many had no pensions whatsoever. This means you and your employer have to contribute a small percentage. Mustachians should be looking to contribute more than this.
- Particularly nasty is the lifetime allowance, which is the maximum amount you are 'allowed' to have in your pension. Anything above the lifetime allowance is taxed at a punitive rate of 55%. Currently it's just over £1m and is meant to rise by CPI inflation each year. However this is prone to particular interference from governments who have habitually tinkered with this allowance. It also includes investment growth, so it is a total value of your pension at the point you start withdrawing, which is called a 'crystallisation event'.
- You can save up to £40,000 per year into your pension, AND ALSO anything up to £40,000 per year from the previous 2 tax years that you haven't put in a pension
- The only modification to this is if you have a high salary (currently above £240,000 - this is all income, so includes ER pension contribution, bonuses etc) and in this event the amount you can save into a pension starts to taper down by £1 for every £2 above this threshold to a minimum of £4,000.
Confused yet?
ISA- In general there are two main types of ISA in the UK: Cash and Stocks & Shares (or an Investment ISA)
- You can subscribe to one ISA of each type in a single tax year. So if I open a Cash ISA with one provider, I cannot open another Cash ISA with a different provider in the same tax year. Adding to an existing ISA in a new tax year is considered as subscribing to a new ISA.
- Your maximum ISA contributions in a tax year are £20,000.
- ISA funds come from net income, so have no tax advantage on the way in, but are tax free on the way out - no income tax is charged on ISA drawdown
- ISA funds (in almost all cases) can be accessed any time you like. This makes them a potent FIRE weapon before you can access the pension plan.
- The exception to this rule is the "Lifetime ISA" which can be of either a cash or investment variety. You can open one of these from 18 up to 40 years old, and once you have opened one you can keep contributing until you are 50 years old. This has a maximum personal contribution of £4,000 per year, but any funds added to a Lifetime ISA get a 25% government top-up, so a maximum annual bonus of £1,000 per year.
- Because of the government top-up there are withdrawal restrictions. You cannot withdraw from a Lifetime ISA without losing the bonus unless 1) You are using it to purchase your first property; 2) You are over 60 years old; 3) You are terminally ill with less than 12 months forecast to live.
- Other than this you can hold funds in any mix you like - so for example you could have £10,000 in a cash ISA, £6,000 in a Stocks & Shares ISA and £4,000 in a Lifetime ISA. The only golden rule is you cannot make more than £20,000 combined contributions in a single year across all the flavours of ISA.
- Other forms of ISA exist, including the Help to Buy ISA (generally less favoured now, if you are saving for a first property the Lifetime ISA is better) and the Innovative Finance ISA (ISA sheltering for P2P lending).
Suggested Investment Order0. Make sure that you are contributing under auto-enrollment to your company pension plan.
1. Establish a minimum-viability cash emergency fund to cover fairly predictable lumpy expenses and avoid more bad debt. I'd tentatively suggest this is £1-2,000.
2. Pay off high interest debt (>5%) as a priority.
3. Increase pension contributions to a higher level. Model for the lifetime allowance.
4. Start contributing to ISAs. If under 40, the Lifetime ISA is your first order of importance.
5. Beef up your emergency fund to your comfort level. For me this is 6 months of household expenditure. Some are comfortable with less as you can always access ISAs in extremis.
6. Max ISA contributions to the total allowed.
7. Look at taxable investment accounts and investing in these also.
Beyond this point a lot depends on your FIRE plan. The general approach of a lot of the UK FIRE community is as follows:
1. Financially Independent, Retire Early - using ISAs and taxable investment accounts to retire early.
2. Pension access age - crack open the big pot of cash in your pension(s).
3. State pension age - add this to your annual income.
There are other ways to approach the same problem - the above assumes you want to do it through investments rather than real estate (to give an example). At a minimum you also want the money in investments you can access to at least bridge spending between Stage 1 & 2 in the FIRE plan above, even if you fully deplete your ISAs/investment accounts by the point you can crack open the pension pot.
At a certain level the lifetime allowance becomes a real pain and it's usual to see some of those closer to FIRE reducing pension contributions to avoid breaching the cap and diverting more into taxable investments instead. Equally, if you want to FIRE then you may choose not to contribute more to the pension due to the gap at which you can access it and contribute more to other investment accounts to speed up the time before you can pack it all in. After all, you can't retire early if all your money is in pension funds you can't access yet. There are other tax-advantaged investments you can make such as VCTs (Venture Capital Trusts) but honestly at this level I'd want to get professional financial advice.
I'm very open to be challenged on both the investment order and the specifics around pensions etc because I'm still learning myself, but this is based on my current knowledge. Final note to say that
www.monevator.com is pretty much the go-to resource on FIRE in the UK and links to most of the other FIRE-minded blogs that cover UK investments and this is where I'd go first to learn more.