Over recent years, the wealthiest have been hit with increasing cuts to pension tax relief, meaning higher earners are now looking for alternative, tax-efficient methods when planning for retirement.
When reviewing the IFISA - considering whether it could be an appropriate investment choice for them - many higher earners will find it provides them with an attractive investment opportunity that can offer high projected returns and could mean they’re able to save more for later life than they could in a pension alone.
Cuts to the lifetime allowance and the introduction of a pension taper
Though the pension lifetime allowance is currently at £1.05 million, it’s still a significant way off its peak of £1.8 million. The maximum annual pension allowance is currently £40,000, however for higher earners this allowance is tapered.
The pension taper was announced in April 2016 (coincidently, around the same time as the IFISA was introduced) and it means that anyone earning more than £240,000 in the tax year will face a reduction in the amount they can save into a pension each year.
The taper caused a little bit of an uproar - with experts describing it as ‘nightmarish’ because of its complex nature - and it’s thought that it could actually disincentivise people from working, and subsequently earning, more. In fact, it’s thought that the pension taper could be partially responsible for staffing issues within the NHS, as highly paid staff within hospitals are opting not to work extra shifts in order to manage the effects of the taper on their pensions.
The Innovative Finance ISA vs Lifetime ISA for retirement
In contrast to drops in pension allowances, the annual ISA allowance has been steadily increasing - rising from £15,240 to £20,000 in the 2017/18 tax year, where it’s stood ever since. It’s also expected to continue this upward trajectory, so it’s no surprise that higher earners are turning to ISAs to act as a supplement when saving for retirement.
The Lifetime ISA was introduced by the government in 2017, and it’s a tax-efficient way of saving for later life (or to buy your first home). The Lifetime ISA is government-backed, offering a 25% bonus. So for every £4 you save, the government adds £1 - up to a maximum of £1,000 per year.
You might be questioning why you’d use an IFISA for retirement planning when the Lifetime ISA is also tax free, with the added benefit of a government bonus. Well, the good news is that you can actually use both.
You can open and contribute to both an IFISA and a Lifetime ISA in the same tax year, so if you’re wanting to take full advantage of both, you can.
But there are some drawbacks to the Lifetime ISA - especially if you’re a higher earner. You can only save a maximum of £4,000 in a Lifetime ISA per year, and anything saved above this is not eligible for the government bonus. The Lifetime ISA also offers low returns of below 2%, similar to the standard Cash ISA. So if you have a significant amount of money to save and/or invest for your retirement, you could very well lose out by choosing a Lifetime ISA over an IFISA, and it may be best to use it as a supplement instead.
The benefits of an Innovative Finance ISA for retirement planning
While Cash ISAs are the most popular form of ISA (though, according to statistics released by HMRC in 2019, they’re in decline) because of their staggeringly low returns of below 2%, they’re probably not the best option for retirement planning.
The IFISA on the other hand, while still relatively new, is performing well - exceeding £1 billion in inflows in 2019. It offers average projected returns of between 4% and 8%, and there’s no tax to pay on interest or capital gains, ever.
With a pension, though you receive tax relief on contributions - 20% for basic-rate, 40% for higher-rate and 45% for additional-rate taxpayers - any income that you take from your pension once you’ve retired is taxable after the first 25%.
Using an IFISA for retirement planning can also give investors more control, choice and flexibility when it comes to where their pension is invested, as IFISAs can be used to invest in peer-to-peer loans or other debt-based securities. So, if you’re particularly interested in supporting small businesses, an SME lending IFISA could be for you, or if you’re wanting to take advantage of the high projected returns offered by property bonds, take a look at property IFISAs. This means not only could you be better preparing yourself financially for later life, you could also be investing in a way that benefits sectors and causes that are important to you.
The variety of IFISAs available means it’s relatively simple to diversify, so if one of your investments was to do badly for any reason, the value of your whole pension pot isn’t lost. While you’re only able to open one IFISA account per tax year, you can still diversify by investing in a range of different types of businesses or projects through a platform that allows pooled funds, or you can open a new IFISA account each year, focusing on a different industry, sector or geographical location each time to mitigate risk.
There’s plenty of choice, and if you were to invest some (or all) of your annual ISA allowance into an IFISA with the view of keeping it there until you’re ready for retirement, you could re-invest the proceeds each year to create a compounding effect. Once you’ve retired, you can start to draw down some of the proceeds as income.
Speaking of income - IFISAs often boast the ability to pay interest quarterly, directly into your bank account. This could provide a relatively steady, dependable stream of income for those in retirement.
Over 4.5 million people in the UK are self-employed, and unfortunately, the self-employed among us don’t have the advantage of an auto-enrolment workplace pension - where you (the employee) contribute 5% of your earnings and your employer is required to contribute 3%. For these people, the IFISA could be used as a substitute for private pensions.
You can usually start withdrawing money from private pensions from the age of 55 - which is already a vast improvement on the current state pension age, which is 65 for men and women and is due to increase to 66 by October 2020. However, with an IFISA you can withdraw money whenever you want to (though this is subject to certain rules).
It’s important to remember that most IFISAs do generally require investors to lock away their money for a fixed term though, and although this is unlikely to be an issue for those who aren’t close to needing to redeem their pension, investors nearing retirement must be sure that they won’t need access to their funds before the end of the investment term.
Using the IFISA to form part of your retirement plan
With their high, tax free potential returns, wide variety of types to choose from - including property, SME and green energy - and the opportunity to use the returns as a regular income throughout retirement, IFISAs are an important consideration for higher earners who have already maxed out their annual or lifetime pension allowances.
You can use an IFISA to supplement an already healthy pension pot, or if you’re self-employed, it could be a viable substitute to the workplace pensions that you miss out on. You can also use it alongside other ISAs - like the Lifetime ISA - to really reap the tax-efficient, pension boosting benefits that an ISA offers.
The CARLTON Bonds product is available exclusively to experienced investors who are classified as either sophisticated investors, high-net-worth individuals or professional investors and have the knowledge and experience to make their own investment decisions. Investments are high risk and illiquid, your capital is at risk and returns are not guaranteed. Bonds are not protected by the Financial Services Compensation Scheme (FSCS).
Originally published 7th February 2020, updated 7th July 2020.