ACCUMUMLATING AN EMERGENCY FUND

Building it up

You should have at least one month’s income in your cash reserve, preferably more.

The alternative, only applicable if you are paying off debt or building up your reserve, is a borrowing facility, that is a source of emergency finance from somewhere else.

This could be a bank overdraft facility or unused credit card balance.

The trouble with these facilities is that if you use them they are expensive, so you need to build up your emergency fund as soon as possible.

Another potential facility is your immediate family; would your parents, for example, be able and willing to make a temporary loan?

Depositing it safely

Use a bank or building society deposit account. Instant access is best, even though higher rates of interest may be available on notice accounts, because the money might be needed in a hurry.

Higher rates are usually available on higher amounts, so it is worth using the same account for any short-term savings such as for your holiday. Postal and Internet accounts often offer higher rates.

Rates change and it is important to check regularly. Comparable rates can be found in newspapers, money magazines and on the Internet. Compare rates of interest by using the AER (annual equivalent rate) to take account of the timing of interest payments.

RETIREMENT PLANNING

Pension scheme contributions

With current tax relief, for those on a marginal tax rate of 22%, a contribution of £100 only costs £78 (and for those on 40% only £60) and then earns income and capital gains free of tax (except that tax deducted from dividends can no longer be recovered). So pensions are a very tax-efficient investment.

When a pension is drawn, it is taxed as income but in most cases some 25% of the pension fund can be withdrawn as a tax-free lump sum.

Contributions to the state pension schemes and occupational schemes are made from income. Personal and stakeholder pension contributions are also usually in the form of regular monthly payments but need not be.

For self-employed people with irregular income, contributions in the form of a lump sum once a year, when you know how much is available, might be more appropriate. Furthermore, charges tend to be lower when contributions are made that way.

Individual pension accounts

With all forms of pension scheme apart from occupational final salary schemes, including stakeholder pensions for which they are specially designed, contributions can be paid into an individual pension account (IPA), which is a ‘wrapper’ like an ISA.

The money can be invested in gilts, unit trust and shares in pooled investment funds and the advantage is that you have control over how the money is invested and can value your scheme at any time by looking up the value of the investments.

If IPA holders change jobs and wish to join their new employer’s scheme, they can either transfer the IPA into the new scheme or leave it where it is, stopping contributions to it as appropriate.

AVCs

These additional voluntary contributions on top of an occupational scheme can also be made in the form of a lump sum and at present it is possible to go back to earlier years if there is space within the Inland Revenue limits on contributions.

There is some debate about whether AVCs are better value than ISAs (See Chapter 7 for ISAs). With AVCs the contribution is tax-free but the benefit is taxable, whereas ISAs are the other way around.

In both cases money in the scheme is free of tax on income and capital gains but ISAs have the advantage that tax deducted from dividends can be recovered until 2004. Charges might be higher for pension schemes than for ISAs.

Most experts favour AVCs because the tax gain comes at the beginning and so funds accumulate tax-free at a higher level. The main advantage of ISAs is complete freedom of action – you can get your hands on the money at any time. However, some people prefer the discipline of not being able to access the funds before retirement.

Cash lump sum on retirement

Most pension schemes include an option to take a cash lump sum on retirement. It is a pleasant decision to make, but it may not be easy. Remember you can choose to take as much as you like up to the scheme limit, but you lose pension in proportion.

If a pension is fully inflation-proofed, then it might be better to keep it intact. If not, then it might be possible to buy an annuity with the cash which pays more after tax than the pension foregone, depending on annuity rates at the time.

You do not have to buy an annuity; you may choose to invest the money differently. You may in any case want to use some cash to pay off some at least of your mortgage.

But think carefully before using it for a holiday or a new car!

Pension annuities

With money-purchase occupational schemes, personal pensions and the new stakeholder pensions, the fund at retirement must be utilised to buy an annuity (this can be deferred in some cases beyond retirement). This is called a compulsory purchase annuity.and all the receipts are taxable (See Chapter 9 for more information on annuities).

PROVIDING FOR SPECIAL EVENTS

These are usually saved for out of income but there is no reason why a lump sum cannot be used.

Special events are normally short-term occurrences, so the money saved for them is usually put in a deposit account; if added to your emergency fund in the same account, a higher rate of interest may be obtained.

If the event is more than three months away, a period notice account might earn more interest. If it is as much as over a year away, then a fixed-interest term deposit could be appropriate.

A period in excess of three years opens up the possibility of National Savings or gilts but a minimum period of five years is recommended for an equity-based investment.

FINANCING YOUR CHILDREN’S EDUCATION

This is another area where savings are normally made out of income but again a lump sum can be used.

The object is to create income of a specified amount (plus inflation) for a specified future period. Take account of each child separately and, in the case of private schooling, do not commit your investment to a particular school.

In this case, if you start early enough, an equity-based investment is worth considering, although as the due date gets nearer a gradual switch to fixed interest would be sensible.

Place your investments in an ISA wrapper (See Chapter 7) if you are not already using your joint annual ISA allowance. In the case of fixed-interest, tax-free National Savings are worth considering if you are not already utilising your full allocations.

Zeros (zero-dividend shares from a split fund – See Chapter 6) are often recommended, as they have a known repayment amount. They also have a known termination date, so a zero can be selected to fit in with your requirements.

It is worth getting independent financial advice and there are specialists in this area.

See Chapter 9 under investing in property for a way of financing university accommodation.

DEALING WITH YOUR MORTGAGE

Using a lump sum to pay off your mortgage is low on the list of financial health priorities because interest rates on mortgages are lower than for other loans. However, the return you get in the form of interest saved is greater than you can get on any investment unless it is very risky, so it is in effect a sensible investment.

There is some advantage in retaining a minimal mortgage because, should it be necessary to take one out in the future, it would make it easier to get and there would be fewer formalities. Also the lender will retain the deeds of the property, usually without charge, which can be convenient.

If you have an endowment mortgage, do not surrender (cash in) the endowment policy as you will get a poor return. It is better to keep paying the premiums until maturity, the less satisfactory alternatives being to make the policy paid-up or to sell it on the second-hand endowment market.

CASE SCENARIOS

Amanda starts a pension

Amanda always felt this was something to be considered in the future but the financial health check has made her realise that she is losing the earlier years for fund growth.

Furthermore, the tax allowances are good at her high marginal rate.

Her employer doesn’t have a scheme and in any case she changes her job frequently.

She talks to an adviser, who directs her to the new stakeholder pension. She would make regular contributions with a lump sum top-up once a year, after she receives her bonus.

Alistair and Jean think about university

Alistair and Jean decide to put away some of the lump sum Jean inherited into a suitable long-term investment to produce amounts to help towards their children’s university education. As this is a specialised area, they consult an adviser in the field.

The adviser suggests putting some of the money into zeros with termination dates which coincide with each of the older two children’s 18th birthday (not many years away), so that they know exactly how much will be available.

In the case of the youngest child, the adviser recommends an equity-based investment as the time-scale is much longer.

Gwen and Hugh discuss their mortgage

Should Gwen and Hugh use some of the lump sum from the pension scheme to pay off their outstanding mortgage? They decide they will, because it would get rid of one financial worry. Also it would make it easier if they choose to move house later on.

They decide to keep a minimum amount in order to get free security for their deeds and to make it easier if they need a mortgage again in the future.

POINTS TO CONSIDER FURTHER

• 1.How do you rate investing in an AVC compared with an ISA? What are the relevant advantages and disadvantages?
• 2.If you have children, would you put money away to help meet the costs of further education or do you think they should learn to survive on students’ loans and earnings from working in the holidays?
• 3.Where does using a lump sum to pay off your mortgage come in your order of priorities? Why could it be a good investment?