The U.K. equivalent of a Roth IRA in 2023
A Roth IRA is a popular saving option for people living in the U.S. But this is not available to people in the U.K. There are two types of alternative accounts similar to a Roth IRA that residents in the U.K. can use.
What is a Roth IRA?
A Roth IRA stands for Individual Retirement Account. It helps individuals save for retirement. The after-tax income is invested and grows free of tax. You can only contribute cash towards this account instead of any other assets, like equities, securities, or property.
There are generally no withdrawal fees provided you meet specific criteria such as being over the age of 59 and a half and having a Roth IRA for over five years. You can also withdraw money early, incurring no penalties if you’re going to:
● Buy your first home
● Cover college expenses
● Cover birth or adoption expenses
Your money is then invested in different assets to provide a return over time, such as stocks and shares, funds and ETFs, bonds, and certificates of deposit. Every year, account holders can deposit up to $6,000 if they’re under 50 and up to $7,000 if over 50 years old. Since your money is held in different types of investments, the returns will depend on what you invest in. This is similar to a few ISAs in the U.K.
The difference between a Roth IRA and a traditional IRA
A traditional IRA is like a personalized pension account. You gain considerable tax breaks since it lowers your taxable income per year and allows you to save money for retirement. Once you retire, distributions are taxed as regular income.
A Roth IRA is similar to a regular investment account, but withdrawals at retirement are tax-free. With a Roth IRA, you contribute your taxed income and get tax-free withdrawals later. While there are fewer restrictions, it does not come with immediate tax benefits.
There isn’t an exact copy of a Roth IRA in the U.K., because of the different tax systems in the U.S. and the U.K. But there are other alternatives.
Alternatives to Roth IRA in the U.K.
There are two types of accounts with similar benefits and growth potential to that of a Roth IRA. They are known as Individual Savings Account (ISA) and a Self-invested Personal Pension (SIPP).
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Individual Savings Account (ISA)
Like a Roth IRA, an ISA is an Individual Savings Account, allowing you to save up to £20,000 of your taxed income per year.
There are four types of ISAs that you can choose:
1. Stocks and Shares ISA
Stocks and Shares ISA, also known as an investment ISA, lets you invest your money tax-efficiently. You have the option to invest in bonds, shares, stocks, and ETFs. Compared to the Roth IRA, Stocks and Shares ISA and other ISAs are more flexible since you don’t have to reach retirement age to withdraw money.
For many, a Stocks and Shares ISA is a suitable alternative to a Roth IRA since it allows you to grow passive income. The investments you make in your portfolio could help you grow your money more compared to relying on interest to grow your money.
2. Lifetime ISA
Similar to a Roth IRA, a lifetime ISA is for anyone aged between 18 and 39 wanting passive income in their retirement or to buy their first home. This form of account is also government-backed, whereby they offer a bonus as an addition to the deposits you place. While a lifetime ISA comes with stricter rules, it helps you build your savings for the long term.
If you withdraw money for other purposes, you will be charged an early withdrawal fee of 25%.
So, it’s important to be certain that you don’t need to withdraw money in the short term before you use it to buy your first home or for retirement.
3. Cash ISA
A cash ISA is a traditional option that lets you create passive income through yearly interest. The interest offered may be fairly competitive for the first year, but it may decrease over time. So, you might have to switch to another Cash ISA the following year to receive competitive interest rates.
4. Junior ISA
A Junior ISA (JISA) is suitable if you have children or grandchildren and want them to learn to save. Once they’re 16, they can take over the account and can withdraw from it once they’re 18 years old.
You can contribute towards a JISA up to £9,000 in the 2022/23 tax year. Since this account will belong to your child, the allowance will be separate from your adult ISA allowance.
There are two types of JISAs:
● Cash JISA
● Stocks and Shares JISA
You can choose one JISA or choose to split your money into both accounts.
If you want to provide a savings account for your children to use when they’re older, a JISA is a great option. It’s tax-efficient and allows you to save and invest beyond your personal ISA allowance.
Self-invested personal pension (SIPP)
Similar to a Roth IRA, a self-invested personal pension is suitable for saving toward retirement tax-free. A bonus of a SIPP account is that you’ll get a 20% tax boost from the government if you commit to it.
You can withdraw money from your SIPP account earlier than a Roth IRA. With a SIPP account, you can withdraw money when you’re 55 years old but with a Roth IRA account you can only withdraw money at the age of 59 and a half.
But, by 2028, the age requirement will rise to 57 years on SIPPs in line with the state pension age. This means that you can start withdrawing money from a SIPP ten years before you are legally able to retire and claim a state pension.
If you’re new to investing, SIPPs can be tricky to organize since there aren’t any managed portfolios. So, you will have to find and pick the best stocks and bonds based on your risk tolerance.
It’s important to remember that with a SIPP, you will pay tax when you make withdrawals. The first 25% of withdrawal is tax-free, but after that, you’ll pay income tax.
Tax relief on SIPP contributions
To encourage individuals to save for retirement, the U.K. government provides tax relief on pensions. This means you can benefit from tax relief with a SIPP account.
The basic-tax relief is applied automatically, but you can claim higher rate relief on your self-assessment tax return.
The pension Annual Allowance limits your tax-efficient savings
The Annual Allowance limits the amount of money you can contribute to your pension pot per year. In the 2022/2023 tax year, the Annual Allowance is at £40,000 or 100% of your income, depending on which is lower. This makes it an attractive option to build a pension pot.
Another benefit is that you can carry forward any unused Annual Allowance for up to three years. For example, if you used up your allowance in the current tax year but didn’t in the previous years, you could use the allowance from up to three years ago.
Which account is best for me and my retirement savings?
To find out what savings account is most suitable, think about your investment goals.
If you want to invest your money without being taxed upon withdrawal and be able to access it without restrictions, then a Stocks and Shares ISA might be suitable for you.
But if you’d rather invest only over a long period towards your retirement without needing to access the money sooner, a SIPP may be right for you.
Alternatively, if you’re not comfortable investing, you can opt for a Cash ISA. It’s important to note that your money might lose its value over time because of inflation.
You can also open multiple forms of accounts to make the most out of the benefits.
Should I invest with a Stocks and Shares ISA?
If you have a mid-to-long-term investing goal, then a Stocks and Shares ISA may be suitable. Remember that investments can rise and fall in value so it’s vital to give your portfolio enough time to grow or recover from market crashes. You need to be confident about putting your money away for several years without touching it.
Can I open a Stocks and Shares ISA for my children?
Yes. You can make use of a Junior Stocks and Shares ISA (JISA). You can invest up to £9,000 tax-free per year.
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