Your top ten money tips for 2008 are:
1. Understand your current position
It might sound like stating the obvious but the starting point of any Financial Planning strategy should be to find out where you are. Even if you know where you want to get to, if you don't know where you currently are you are likely to be much less efficient in your route to financial success.
The four main aspects for your current financial position are income, expenditure, assets and liabilities. If you have a good understanding of these, you are already one step ahead of most people.
With your income, you should make the distinction between earned income, rental income and other income. Bank/building society interest and dividends from investments are not really income, they are just a return on your investment. Earned income would be salary/bonus or pension income if you are retired. Rather than using a gross income figure, you should work out what your net monthly income is.
Have you noticed any trends in your income over recent years? Are you currently a higher rate taxpayer or likely to be one in the near future? If your partner is also working is he or she a higher rate taxpayer?
If you have worked out your net after tax income you will have already calculated how much you “spend” on Income Tax and National Insurance each year. You should then work out as accurately as possible how much you spend over the course of the year. This should be divided between essentials such as household bills and items that are nice but non-essential, such as holidays. Take care not to include monthly savings into bank accounts or investments as expenditure. Quite simply, if your net income is lower than your expenditure then you've got a problem that needs addressing. Any excess income over expenditure is available for you to invest for your long-term financial well-being.
The next step is to analyse your assets. This could be your home, your investment property, your investment portfolio, your pension or your savings account from example.
Once you have a headline summary of your assets, you should try to work out what the tax treatment of each is. Are they tax-efficient based on your current income tax position? It is very easy to increase returns without increasing risk, just by making your investments more tax-efficient. Few people do this very diligently though.
Finally, list your liabilities and make a note of what interest rates you are paying on each. If you don't know what the interest rate is, and most people don't, find out as a priority.
2. Don't get stuck on the SVR
Most people don't choose a Standard Variable Rate (SVR) mortgage; it's the rate your lender switches you to when your initial offer period expires.
With many 2 and 3 year fixed rate mortgage deals coming to an end, homeowners should be very careful not to get stuck on their lender’s SVR. The Bank of England Base rate was 4.5% in December 2005. By December 2007 it was 5.5%. Base Rates have since dropped to 5% (April 2008) but mortgage interest rates haven’t been falling in line with this. SVRs are usually 1% to 2% higher than this. You could therefore easily see a rise from 4.5% to 7.5% on your mortgage interest rate. On a £200,000 interest only mortgage, this would represent an extra £500 per month of interest.
Whilst borrowers will have to accept an increase in mortgage costs, taking no action and accepting the SVR will not lead to a comfortable 2008. If you find that you are currently paying your lender’s SVR, it's never too late to remortgage to a cheaper deal but make sure that you check the terms and conditions of your existing mortgage first
3. Improve the rate of return on your cash
You should make sure that you are getting a decent return on your savings.
Whereas many current accounts pay a negligible amount of interest, good savings accounts will pay in excess of Bank of England Base Rates for their easy access accounts. As at April 2008, ,the UK Bank Base Rate stands at 5% p.a. Higher interest rates can be obtained through notice accounts if you are prepared to tie your money up for a given period of time.
It is not practical to always be chopping and changing savings accounts but you should make sure that the interest rate is at an acceptable level. With this in mind, be careful with accounts that pay a very attractive introductory interest rate and then systematically cut this. With these accounts, banks are relying on saver apathy to keep the business.
Taking an example of £10,000 in a nil interest current account, if this were moved to a savings account paying 5.5% interest per annum, this would represent additional interest of £550 each year before tax. That could pay for a weekend in Paris!
This may seem like a very simplistic Financial Planning strategy but the truth is that far too many people throw money away by not managing their cash effectively. Don't let it be you!
4. Improve the tax efficiency of your cash
Following on from the example above, £550 of interest before tax would equal £330 after tax for a higher rate taxpayer and £440 after tax for a basic rate taxpayer. A non-taxpayer should complete a R85 form to enable them to receive the interest gross.
It can really make sense to take advantage of the different taxation levels to maximise your after tax return. For example, if you and your partner have joint finances, you should make sure that most of your cash is held in the name of the lower rate taxpayer. A higher rate taxpayer will pay 40% income tax on savings where as a basic rate taxpayer will only pay 20%.
In many cases, one partner will be a higher rate taxpayer and one partner a non-taxpayer. Therefore, on the example of £10,000 attracting 5.5% p.a. interest, a simple strategy like this could represent the difference between having £330 in your pocket and £550.
Many couples hold their savings in joint accounts but remember that interest on these will be taxed as if 50% is one partner’s and 50% the other’s. This is therefore not always tax-efficient. The above therefore represents another way of vastly improving your net return without having to take any additional investment risk at all.
5. Make the most of employer benefits
Many employers offer their staff a range of benefits as well as salary and bonus.
With some of these benefits you may have to make an active decision to join whereas with others, enrolment could be automatic. You should check what is on offer to you (ask your HR department) and make sure that you are taking advantage of these.
Typical benefits might include:
Life assurance – this is often 4 x salary. Remember that if you leave the firm, you will lose the insurance (and you might be in poor health at the time) so where you want to make sure that your family is well provided for in the event of death, it often makes sense to have some insurance outside of your employer scheme.
Pension – this could be a final salary scheme or a “money purchase” scheme such as a stakeholder pension. Your firm could well have an appointed pensions adviser to help you with decisions on this.
Income protection (also known as permanent health insurance) - big employers often give you up to 75% of salary (minus state sickness benefits) in the event of long-term illness. You may also be covered on full salary for 6 months. This is usually only on basic salary, not bonus and is taxable so it might not be enough to protect you and your family.
Increasing numbers of employers are now offering flexible benefits packages through which you can buy extra holiday, childcare vouchers, extra life insurance, home computers, critical illness cover, medical insurance for the family etc. Such schemes are fantastic because many of the benefits you buy are tax deductible, i.e. the cost comes off your pre-tax salary.
6. Join your Save As You Earn Scheme
Offering employees share option schemes is an increasingly popular way of giving workers a stake in the companies they work for. In the past 10 years, an estimated £100bn of shares have been transferred to employees with companies recognising the benefits of giving employees an incentive to work harder for the good of the business.
Many large firms will offer SAYE or “Sharesave” schemes. These allow employees to save between £5 and £250 per month for 3, 5 or 7 years.
Employees get a tax-free bonus if they complete the savings plan. Employers grant employees an option at outset. At the end of the period, employees choose either to use the money saved, plus the bonus and interest, to buy shares (if buying the shares would generate a profit) or have their contributions returned plus interest (if this would give the higher return).
SAYE schemes offer huge upside potential with very minimal risk. Essentially, if the share price falls during the period, you will still get your savings back plus a tax-free bonus so the only “risk” is the fact that you could have received a slightly higher return through a conventional savings account. Other employee share schemes can involve giving free shares to employees, granting options to buy shares at a set price after a specified period of time, or allowing employees to buy shares, and matching these with free ones.
7. Maximise ISA opportunities
One of the best ways to improve the performance of your investment portfolio is to make sure that it is as tax efficient as possible. Making use of the Individual Savings Account (ISA) allowances each year is an excellent way of doing this.
When taking a longer term view, ISAs represent an excellent opportunity to build up a substantial, tax-efficient portfolio. The key is not to be put off by short term market fluctuations. ISAs are one of the few tax-efficient wrappers left, although you should be aware that they are not strictly tax-free any more. Since 6th April 2004 it has not been possible for ISA managers to reclaim the 10% tax credit on dividends from UK equities. What this does is negate the income tax benefits of ISAs for lower or basic rate taxpayers.
There are still a number of advantages:
- Higher rate taxpayers do not need to pay the balance between basic and higher rate tax on dividends.
- All gains within ISAs are free from Capital Gains Tax. In addition, switches can be made without you having to worry about the CGT implications.
- All income received from fixed interest holdings is tax free.
- Personal administration is kept to a minimum as you will not need to declare any income or gains on your tax return.
8. Don't try to time markets
Markets will always have their volatile periods and no one can predict which weeks or months will generate good or bad returns and how long those periods will last. However, being out of the market for even short periods can markedly affect long-term portfolio performance.
The table below, compiled from data provided by Dimensional Fund Advisors, shows the performance of the FTSE All-Share Index between January 1986 and December 2006. This compares the overall compounded annual return if an investor keeps his funds permanently invested, and what happens when certain periods of time are missed. For comparison purposes, short and long bond returns are included. The message is that it is very easy to get it wrong.
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Market timing
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Compound annual returns
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Fully Invested
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11.74%
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Missed 1 Best day
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11.44%
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Missed 5 Best single days
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10.40%
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Missed 15 Best single days
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8.37%
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Missed 25 Best single days
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6.72%
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UK One-Month T-Bill
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7.53%
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Long-Term Govt. Bonds
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9.15%
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Source: Dimensional Fund Advisors
It is striking to note that if the fifteen best days were missed in the All-Share in the period 1986-2006, then investment returns would have been reduced by almost 29% and if the 25 best days were missed then the returns would have been lower than one month T-bills.The chance of investing at the right time is so slim that it is not worth trying. Where practical, it makes sense to spread lump sum investments over a number of stages at monthly, quarterly or even longer intervals to reduce market timing risk.
9. Delay pension contributions
This might sound counter-intuitive but it can be a valuable financial planning tactic in certain circumstances.
There is a general misconception that retirement planning means paying money into a pension. A pension is simply a tax-advantaged investment wrapper. Indeed, for tax efficiency and flexibility, it is often best to hold a mixture of pensions, ISAs, cash and other investments at retirement.
Pension contributions attract tax-relief at your marginal rate but are then taxed when you draw benefits. For higher rate taxpayers, a £60 net pension contribution will be ‘grossed up’ to £100 with the benefit of 40% tax relief. For higher rate taxpayers this actually means an immediate 66% enhancement on your investment.
For those who do not pay higher rate tax, there is an advantage in making any additional savings into an ISA. Like a pension, the money can be invested into equities which, over the longer term should outperform cash and fixed interest assets, but at retirement, the fund can be converted to fixed interest and any income would be tax-free. If you are a basic rate taxpayer now but feel that you are likely to become a higher rate taxpayer in the relatively near future, why not consider delaying contributions until you can obtain higher rate tax relief.
10. Look after the pounds, not the pennies
We have demonstrated that there are many ways to make your finances as efficient as possible. Personal finance needn't be complicated and most people could improve their financial position significantly just by implementing a handful of the ideas suggested above.
However, none of us should lose sight of the fact that there is more to life than money. The end result of taking more control of your finances should be that you have more free time and money for the interesting things in life such as family and holidays.
Whilst it is important to make positive changes, we all have to draw a line somewhere. You may not personally be too interested in having the absolute best interest rate on your savings or the lowest possible interest rate on your mortgage. As long as the rates are good, that may be enough. Frankly, you may have better things to do with your life than trying to chase the few extra decimals of return.
A more satisfying approach would be to look after the pounds by getting the important decisions right and not waste time worrying about the pennies.
This document is intended for informational purposes only and no action should be taken or refrained from being taken as a consequence of it without consulting a suitably qualified and regulated individual. It does not constitute financial advice under the terms of the Financial Services and markets Act 2000. It is not an offer to sell, or a solicitation of an offer to buy, any of the instruments or schemes described in this document. Past performance is not an indication of future performance. The value of tax benefits depends on individual circumstances and is subject to charge.
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