Everyone wants to build wealth. Sure, money isn’t everything in life, but it helps give you peace of mind and comfort. Besides working and owning your own business, there are three main ways that people build wealth in the UK and these are pensions, investments, and property.
Pensions
In the UK, you have a few different types of pensions: state pension, workplace pension, and private or personal pension. In each of these, a certain amount of your income is deducted out of your paycheque to save for retirement. The money is not available to your current self, but it will be made available to your future self. Simply put, you probably don’t want to work for the rest of your life, which is why a pension is key to ensuring a dignified retirement. The types of pensions are self-explanatory.
Obviously with the state pension, you can’t opt out of that. If you’ve worked for a certain period of time in the UK, you can claim state pension later on. We won’t get too much into this one, but we will talk more about workplace and private pensions because the focus is on building wealth.
Workplace Pensions: Defined Benefit and Defined Contribution
A workplace pension is available through your job. There are two different types of workplace pensions: defined benefit and defined contribution. Defined benefit schemes guarantee a future income for you in retirement and while they’re not as common as defined contribution schemes, they are often offered to those who work in the public sector or large corporations. With defined contribution, it’s just a pot of money that is built up over time with both you and your employer contributing to it, matching your contributions up to a certain amount.
Private Pensions
A private/personal pension is always defined contribution and is based on your contributions to your personal pension pot.
The biggest benefit with pensions is that you can pay less in tax and have more money later on via a salary sacrifice arrangement through your workplace where you pay into your pension before you get paid and you pay less tax because it’s not part of your paycheque. But what if you’re paying into a personal pension? You can still get tax relief added to your contribution.
Let’s think of it in terms of numbers, if you contribute £100 into your pension pot, that effectively becomes £125 thanks to tax relief. And it gets even better from there because that money in your pension pot grows tax free over time through investment. In a defined benefit scheme you don’t get to pick how the money is invested, that is up to the pension trustees, but with defined contribution, you can either go with a default option that’s middle of the road or you can look at different investment options – you might want to speak to an independent financial adviser about this though.
Simply put, this is the most tax efficient way of building wealth and it’s investing in your future. The downside is you won’t have access to that money for some time, until you’re at least 55 or 60 and that’s a long way away for those in their 20s and 30s. Still, at that age, you’ll want to think in the long term and get the financial foundations right.
When it comes time to withdraw money from your pension, you can either go with a lump sum or monthly payments. Either way, you’ll have to pay income tax on it when you retire. Remember that the first £12,750 is tax-free. Between £12,751-£50,270 you’re taxed at 20% – which is basic rate, between £50,271 and £125,140 you’re taxed at 40% which is higher rate, and from £125,141 you’re taxed at 45% which is additional rate.
ISAs
ISA stands for Individual Savings Account and there are four types of ISAs: Cash ISA, stocks and shares ISA, innovative finance ISA, and lifetime ISA (there are cash and stocks and shares lifetime ISAs). Any UK resident who is 18 or older can open an ISA at various places such as a bank, building society, credit union, friendly society, stockbroker, or another financial institution. Parents can open a junior ISA for their children who are under 18. Everyone has a yearly ISA allowance of up to £20,000 and you have the choice between putting that money into one ISA or multiple ISAs.
Unlike salary sacrifice pensions, ISA contributions are made from post-tax income, but the money within your ISA grows tax free. There is more flexibility in withdrawing from your ISA and you can withdraw money when you need it tax free an this means ISAs are great for both short term and long term savings goals. If you have a flexible ISA, you can take out money and later put back in the money that you took out in addition to your remaining ISA allowance.
Lifetime ISAs (LISA) come with more restrictions and you can only withdraw money tax free under a few circumstances such as if you’re buying your first house or you’ve reached the age of 60. You can of course withdraw money from a LISA, but you’re going to be charged a 25% penalty. You can put up to £4,000 per year tax free into a LISA.
Property
Much of people’s net worth is going to be their home. In general, property goes up in value and you can see this if you look at the cost of rent versus the cost of a mortgage. Rent can always go up after your lease is up, but a fixed rate mortgage stays the same for the period of time the mortgage is for. But that’s not the only way that people build wealth in property.
Lodgers
Some people may become landlords and buy a small house or flat to let or if you have extra space in your house, you could rent out an extra bedroom in your house to a lodger through the Rent a Room Scheme where you can earn £7,500 per year tax free for simply renting out extra rooms in your house, but you must be a live-in landlord.
Buy-to-let
With buy-to-let there is a potential for high returns on your investment and you need less initial capital than one would need to start a business, but it’s not as tax efficient because of recent law changes and buying property is not without its risks. When you own property, you are responsible for maintenance and that can be expensive, especially with fixer-uppers that would be cheaper than move-in ready houses. There’s also the risk that tenants could fall into arrears and with renters rights it can take time to evict. Even with good tenants that pay the rent on time, if they leave to buy a house or find another place to rent, it’s hard to find another good tenant to replace them.
In Conclusion
I hope this blog post provides a clear and helpful overview of building wealth through pensions, ISAs, and property investments. If you have any questions or need further advice, feel free to reach out to book your free discovery meeting.