Once you have a solid monthly budget in place and have some money saved in case of emergencies, you can put your disposable income to good use for your long-term financial goals (usually considered beyond five years).
What your long-term goals are will depend on your personal situation and might include retirement planning, for example, or saving money towards your children’s university tuition.
In the very long term, you may also want to consider inheritance tax, and how to pass on the maximum amount possible to your beneficiaries.
Increase monthly contributions and take advantage of tax-sheltered accounts
For long-term goals, the earlier you start investing the better. This is principally due to the power of compounding, where you earn a return on your return. So strong is the power of compound interest, that Einstein reportedly called it the eighth wonder of the world.
Another important way to leverage the power of compounding is to increase the amount you set aside each year. As we show in the chart below, paying in more each year can make a massive difference to how much you eventually end up with.
Invest more, get much more
Notes: This hypothetical scenario is for illustration purposes only and doesn’t represent a particular investment or its expected returns. It assumes annual returns of 6%, while monthly returns are assumed to be the geometric averages of these values. Contributions are monthly and are made at the end of each period. Balances reflect the value at the end of each period. The chart doesn’t account for taxes and management or platform fees.
In our hypothetical example, three households opened an investment account to fund a goal in 30 years. All three initially contributed £10,000 to the account but the second added a monthly contribution of £500 while the third contributed £500 monthly but also increased their regular investment by 5% each year. For simplicity, we have assumed a fixed rate of return of 6% each year, compounded monthly.
When you are saving for a long-term goal, remember to shield any investments from tax. A simple way to do this is to invest in an individual savings account (ISA). ISAs allow your money to grow free from the income tax you might pay on the dividends or interest you receive, as well as the capital gains tax (CGT) that could be applied on any profits that you make.
You may also benefit from tax relief on your contributions into a pension but don’t forget that you won’t be able to access it until you are 55 (rising to 57 from 2028). The government recognises that pension contributions come from post-tax income, so essentially gives you the tax back when you pay into a pension. For basic rate taxpayers, the government will give you back 20p for every 80p contributed, while the figure rises to 40p for every 60p contributed for higher rate taxpayers and 45p for additional-rate payers. Don’t forget that your employer may also match any savings into your workplace pension.
Pay down lower interest debt
When thinking about multi-year goals, you also need to work out how longer-term debt fits into the picture. This can include mortgages, for example, or some types of student loan plans1.
Whether it makes sense to repay comparatively lower interest rate debt early - like a mortgage - depends on a variety of factors, including the interest rate and what you might expect to make investing instead. For most people, achieving a balance between taking advantages of tax-advantaged investments and mortgage repayments is what matters.
Remember to factor in how tax might reduce your investment returns too. If you invest outside of an ISA or pension, for example, you may have to pay capital gains tax, which would reduce any gain by 20%2. Maximising your wealth is also not the only consideration. Repaying your mortgage offers the certainty of avoiding interest costs, while investment returns are unknown.
How will you pass on your assets?
Many people will also be thinking about inheritance tax and how they can pass on the maximum amount of inheritance as possible. Inheritance tax is only levied on estates with a value of more than £325,000, with this limit known as the nil-rate band (NRB)3. There is also a residential nil-rate band (RNRB), which gives you an additional £175,000 free of inheritance tax if you are passing on your home to your direct descendants.
Transfers between spouses and civil partners do not attract inheritance tax, with the unused percentage of your NRB and RNRB passing to your spouse on death. This means that a married or civil partnership couple can effectively pass on assets worth £1,000,000 without an inheritance tax liability4.
In addition, pensions typically fall outside your estate so can be passed on to your beneficiaries free of inheritance tax. If you die before age 75, your beneficiaries will usually be able to make tax-free pension withdrawals. If you die at 75 or older, withdrawals will be taxed as part of their income.
Beyond that, there are a variety of ways you can minimise inheritance tax, including giving away assets, certain types of investments or taking out insurance to pay for an inheritance tax liability. This is a complicated area of financial planning, however and regulations often change. You should seek financial advice when trying to mitigate inheritance tax.
Feel financially better
Now that you have finished our series on financial wellbeing, it’s time to take matters into your own hands. Have a look at our proposed checklist below to complete your financial wellbeing. For even more help around investing and financial wellbeing, keep up to date with our latest articles.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The eligibility to invest in either ISA or Junior ISA depends on individual circ*mstances and all tax rules may change in future.
Any tax reliefs referred to are those available under current legislation, which may change, and their availability and value will depend on your individual circ*mstances. If you have questions relating to your specific tax situation, please contact your tax adviser.
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