Want to retire early? Use your Isa as you wait for your pension

The pandemic has forced us to reassess our priorities, and many are use their Isa to achieve the desire to stop working sooner.

“We are seeing a growing number of clients under the age of 50 that want the option to retire before age 57,” said Lisa Tipton from New World Financial Group. “Isas can usually be accessed at any age, and without any tax to pay. They can provide a useful tool to bridge the gap until you can access your pensions.”

Here’s how you can use your Isa to retire early.

Which type of Isa?

A stocks and shares Isa is most suited to long-term savings of at least five years. Investing in the stock market can be volatile, so it’s important to have time to ride out the ups and downs, but over the long run your savings are likely to grow at a faster rate than in a cash account. You can choose a wide range of investments, and your returns will depend on the success of them.

The average stocks and shares Isa grew 6.9 per cent in the year to February 2022, according to data from Moneyfacts, while the average cash Isa paid interest of 0.51 per cent.

But if you are close to retirement, or have already retired, a cash Isa may be a more suitable choice. Cash Isas pay a set level of interest and while it is likely to be well below inflation, you have the certainty of knowing that your money will not go down.

There is also the Lifetime Isa, which can be used as an alternative to a pension. Savers cannot withdraw money from it before the age of 60, so a Lifetime Isa will not be suitable if you are saving for early retirement before then.

Where should I invest my money?

The answer to this depends on how far away you are from retiring. Generally the rule is that the younger you are, the more risk you can take.

So if you are, say, 20 years away from your retirement goal, you can take a high level of risk. A high-risk investment strategy would involve putting the majority of your money in equities (also known as company stocks).

If you are less than seven years away from retirement, a less risky strategy may involve putting more money into government or corporate bonds. Here, investors have certainty of getting their money back with interest.

Rather than picking stocks and bonds yourself, you could put your money into a fund that invests in a wide range of assets on your behalf.

Followers of the Fire movement (Financial independence, retire early) commonly put their money into the Vanguard LifeStrategy funds. The highest risk fund is LifeStrategy 100% Equity and the lowest risk is LifeStrategy 20% Equity. You can open a stocks and shares Isa with Vanguard directly, or you can buy a LifeStrategy fund through other providers such as Hargreaves Lansdown, AJ Bell, Interactive Investor and Fidelity.

Other popular Isa funds include Baillie Gifford American and Fundsmith Equity, according to Hargreaves Lansdown.

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How much will I need to retire early?

To calculate this you’ll need to work backwards — you first need to consider how much you will need to live on.

A single person would need a minimum income of £11,000 a year to meet basic living standards, according to the Pensions and Lifetime Savings Association (the full state pension is £9,339 a year), while the amount required for a moderately comfortable lifestyle would be £20,800 a year and a comfortable retirement would cost £33,600.

Financial advisers typically recommend withdrawing less than 4 per cent a year from your savings (regardless of how much you have saved) to reduce the risk of running out of money in retirement.

Isa savings can be used to bridge the gap if you decide to retire before you can get access to your private pension at age 55, or to provide extra income until your state pension kicks in at 67.

The downsides

The main benefits of Isas are their flexibility and tax-free status, but there are some downsides.

There is a cap of £20,000 a year on how much you can save into any Isa product. If you are looking to save more than this, you will have to save into an investment account outside the Isa wrapper.

They are also liable for inheritance tax. Most people in the UK will not have to worry about inheritance tax (IHT). But if you have assets of more than £325,000 (£500,000 if you pass on your main home to a direct descendant), then your beneficiaries could be charged inheritance tax of 40 per cent. Anything left to a spouse or civil partner is IHT-free and they can also inherit any of your unused IHT allowance, giving a total amount of £1million that a couple can pass on to relatives without them having to pay tax.

Money saved in a pension can be passed on to family members or dependants free of inheritance tax.

Isa or pension?

In reality, many people use both when saving for retirement.

Isas are helpful if you plan to retire or semi-retire before you can access your pensions and they are useful for anyone whose pension income pushes them close to a higher income tax bracket because any money you take from them is not counted for income tax purposes.

Isas are also used by savers who max out their pension contributions each year. The most a basic rate taxpayer can pay into a pension and still get tax relief is £40,000 a year, but for the top earners this allowance is tapered down to a minimum of £4,000 a year.

Overall, pensions are more cost efficient ways to save if you plan to retire after your late 50s, because of the tax relief you get when you pay into a pension and your employer’s contributions, but an Isa top-up could bring that retirement dream a little closer.