If you’re trying to optimise things, you’ll have slightly conflicting goals. You want as much free money as possible from using pensions, but you want to ensure that you have money available and not tied up till pension access age, to fund the earlier part of your early retirement.
We refer to this as “bridging” till pension access. The best place to put this bridge fund money is in a stocks & shares ISA. (Jargon:"Individual Savings Account".) You can get at money in an ISA at any time.
ISAs
Currently we can all put £20,000 of new money into an ISA each tax year. (The tax year runs from April 6th to April 5th.) Once filled, that’s it till next April, when you can add more money.
This allowance is across all sorts of ISA. Currently the others are Cash ISAs and Lifetime ISAs. Cash ISAs are easy - you can transfer money freely from a Cash ISA to a S&S ISA and vice versa.
LISAs
Lifetime ISAs are a different thing, they’re sort of a hybrid between an ISA and a pension. You can open them until you’re 40, and can put in up to £4k a year until you’re 50, which like a pension gets a government top-up of 25%. LISAs can only be drawn upon once you’re 60, or for a first time buyer to use as a house deposit. They have a slight advantage over pensions in that upon retirement the money is all tax-free.
If you make use of a LISA, your contributions count toward your overall ISA allowance. So if you put the maximum of £4k into the LISA, you only have £16k remaining to fund your main S&S ISA.
How Much Bridge Fund Do I Need?
If you are doing this in your 20s, planning a retirement in say your 30s, pension access age is a distant dream and the heavy lifting will need to be done by your bridge fund.
On the other hand, if your target retirement age is your early 50s, then you’ll only need a few years funding before your pension kicks in.
So in this respect, your bridge fund should be as small as possible, to safely get you through.
Tax Optimisers
At the far end of this process, your priorities get reversed a little bit. ISA money is all tax-free. Pension money, meanwhile, counts as “income” and attracts income tax. Boo! Okay, there are some tax breaks - 25% of any drawdown is tax-free, and then you have the tax-free Personal Allowance to use up each year before income tax becomes due. This is currently £12,570. This means that you could draw about £16,000 from your personal pension before paying any income tax. Pretty good. And this system is kind of fair if you consider that you were allowed to defer paying tax on your income back when you earned it and put it into the pension, on the basis that some of it would be taxable later on.
When your State Pensions kicks in, it also helps use up your Personal Allowance. So for the optimisers among us, your goal in retirement will be to burn up your pension money as quickly as possible while staying under the income tax wire, shunting what you can into your ISA, before your State Pension comes along and uses up all your allowances.
This sort of planning is far down the road, and all the governments in between are likely to move the goalposts!
Planning
At the outset, it doesn’t hugely matter what split you choose between ISA and SIPP. You’ll have years to make course corrections.
One thing to bear in mind is that pensioned money becomes inaccessible until you’re pushing 60. (The exact date is another thing the politicians keep tinkering with.) So if you are likely to need this money for any crises or life events before then, consider keeping enough accessible. On the other hand, putting it in your pension is a great way to see your total climb quicker.
You can model this using fireplanner to get a sense of how changes to these choices impact the outcome. It’s not an exact science, but it will certainly give you a broad idea.
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