With the massive returns seen from passive income in the crypto space it’s easy to get excited and ignore other options and forget about risk mitigation. And whilst I suspect the better returns will come through other means, I do pay regularly into a pension (which I could withdraw from age 55) and lump sums into a stock and shares ISA (which I can withdraw tax-free anytime).
These are tax-efficient savings (future passive income!) options in the UK and you’ll likely have something similar in your own country. And I was a late-starter when it comes to ISA and pension; should have started many years earlier!
In the UK, you get tax relief on any money you put into a pension. That basically means if you are a tax payer paying 20% tax, then the government will add 20% to whatever you input to your pension. For example, if you input £100, the government will add 20% (£25) meaning £125 has just been invested.
If you are paying 40%, then you’ll get 40% relief ie. if you input £100, the government will add 40% (£40) meaning £140 has just been invested.
If you’re an employee, you should have a pension from your employer and there’s a good chance that you can pay extra into it and the employer will match or increase their contribution – essentially giving you free money (+ the tax relief). Ask your employer or HR department. I don’t know too much about this as I’ve never really been employed, but I do know that pension benefits vary hugely from company to company and should be taken into consideration if you are seeking employment.
What pension do I use?
I use a Self-invested Personal Pension (SIPP) and am with Vanguard. I make a monthly contribution for which Vanguard automatically claim tax relief. I can stop/pause my contribution at any time and top up extra at any time.
It’s completely hand’s free.
Within Vanguard, they have some really easy options to choose from based on your risk tolerance and/or the age you wish to retire + your targets. The Vanguard LifeStrategy funds are very popular blended products of equity and bonds (or 100% equity), and they also have other share-based funds to choose from.
I’m currently distributed between 3 funds; the Global Small-Cap Index, LifeStrategy (100% equity) and the S&P 500 UCITS ETF.
Further pension information
Whilst there is tax relief on pensions contributions, you will be taxed when you start drawing out (at whatever rate of income tax you fall into). However, getting that initial 20%-40% boost means the investment over time still makes pensions a cracking deal and one of the easiest ways to save for your future.
In the UK, the state pension is the money the government pays you IF you have paid enough years national insurance contributions. You need 35 years to qualify for the full state pension amount and 10+ years to get a partial pension – anywhere between 10 and 35 years is weighted. It doesn’t kick in until you are 66/67 depending on when you were born.
You really should have a pension outside of this (eg via your employer or a SIPP) as the state pension is not a lot of money. However, keeping your national insurance contributions up to date (ie paying into your state pension) is probably the best spend of money you can make in terms of pensions. It’s very important you look into where you stand if you are self-employed and/or have had gaps in employment because you can pay to ‘top up’ any gaps for up to 6 years.
Unlike the state pension (also referred to as old-age pension) which can only be claimed from the age of 66/67, your employee pension can usually be claimed a bit earlier eg 60-65. Anything that goes into a SIPP can be claimed from age 55 — which is actually quite young. You’ll also have the opportunity to take a lump sum if you wish.
ISAs (Individual Savings Account)
Every person in the UK is entitled to open an ISA and save/invest up to a maximum amount each year (currently £20,000 per year). The big difference between ISAs and other savings accounts are that they are tax-free ie. any gains you make will not be taxed when withdrawn.
The UK tax year runs from 6th April to 5th April. Once the year ends, you get a new allowance (currently £20,000) that you can save/invest.
There are a few different types of ISA. For example, there is a cash ISA (and various types of cash ISA) however the returns are tiny. Then there are Stocks and Shares ISAs…and this is what I use.
What ISA do I use?
Currently I use Freetrade. The reason I chose Freetrade is because the app is easy to use and I was also able to pick individual stocks, Index funds aka Trackers (eg follow the FTSE100 or the S&P500) ETFs (similar to trackers, they represent a basket of stocks) and managed investment trusts.
A similar app is called FreeTrade 212, which I really like and may move too because they have a cool feature called ‘Pies’. If you use either of those links to register, you will receive a free random share!
I’ll admit that initially I went a bit ‘click happy’ on the share purchasing – these apps make it too easy & I ended up with a heap of shares in small quantities which I later consolidated. However I haven’t touched anything since about October 2020.
My main portfolio is made up of SMT (Scottish Mortgage Investment Trust), Fidelity China Special and BG US Growth (Baillie Gifford). I let those guys deal with picking stocks! I also have individual shares in Square, Beam Therapeutics, Teradyne, Etsy, Slack, Peloton…and I had to put a bit into Coinbase (although thankfully I waited a few weeks after the initial IPO!) and of course our local Belfast heroes, Kainos. There’s also a few more but I’ll not bore you with the list.
Currently my portfolio is up about 20% for a year to date — at one point it was up around 40%. Whilst not quite so crazy as crypto, there can still be massive swings in stocks and shares.
My stocks and shares ISA can be as active as I want it to be (it’s ‘free’ to buy and sell my stocks/shares), however for 8 months it’s been completely passive – I don’t trade.
Further ISA information
Unlike pensions, where the tax relief is given to you in advance, with an ISA, the tax relief is when you withdraw. Basically, you do not pay any tax when you withdraw. And that’s pretty awesome — even moresoe if you’re a higher rate tax payer at the time of withdrawal (eg paying 40%+).
Let’s say that I were to start with £20,000 and managed 13% per year. Compounding that over 20 years would give me around £230,000. And I could withdraw that £230,000 tax-free!
You get a new allowance every tax year. You can open a new account or just add to your existing one.
If you are under 40, it’s also worth looking into a Lifetime ISA (LISA) which has some added benefits, especially if you are not yet a homeowner.
For me, putting some of my money into a SIPP and an ISA (alongside paying off a mortgage) are the more traditional tools I use to be financially secure. It also spreads the risk a little and give me additional peace of mind whilst I’m growing my passive income through some methods that would be deemed riskier.