1.2 Create an income for life

scrooge mc duckChapter Overview

How we defer making difficult (investment) decisions and why that kills the benefits of compounding interest.

S&P 500: The Standard & Poor’s 500 is a US stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

It differs from the Dow Jones Industrial Average (chapter 1.1) because of its diversity and weighting methodology. It is one of the most commonly followed equity indices, and is considered to be one of the best representations of the US stock market, and an accurate forecast of the state of the US economy in general.

The closest UK equivalent is, again, the FTSE 100 (chapter 1.1) although other indices also exist, for example, the FTSE All Share Index which includes stocks of about 1,000 companies.

401(k): A tax-deferred, pension account defined in subsection 401(k) of the US Internal Revenue Code – introduced by Congress in 1978. Contributions are deducted directly from the employee’s payslip before taxation, and sometimes matched by the employer.

The main benefits of this system are:

  • Automatic deduction of contributions
  • Contribution matching by the employer
  • Contributions not taxed at source

Roth 401(k): Although not mentioned specifically in this chapter, this seems a good place to deal with it.

“Roth” refers to Senator William Roth of Delaware who promoted setting up a new kind of Individual Retirement Account (IRA) in 1997. A Roth 401(k) is a hybrid of a traditional 401(k) and a Roth IRA.

Essentially, contributions to a Roth 401(k) are made after deducting tax rather than before tax in a traditional 401(k). When a traditional 401(k) plan pays out, tax is then deducted at the rate current at that time, but income from a Roth 401(k) is tax free as long as some basic conditions are met.

The Roth IRA advantage is that income is tax-free which can help with future tax planning. It also allows people to contribute beyond the permitted limits of the traditional 401(k).

This is clearly a complicated subject with a lot of US-specific tax rules and regulations which I’ve not made much (more) of an effort to understand. What I do need to know is what the UK equivalents are – and what tax rules are currently in place.

If you’re employed, and your employer also contributes to your pension pot, the UK equivalent of a US 401(k) appears to be a Defined Contributions Pension Scheme – where contributions have tax reductions applied to both the investment and returns.

If the employer isn’t so generous or you’re self-employed, a Self Invested Personal Pension (SIPP) seems to be the equivalent of the US IRA.

Then, of course, there’s the state pension for those who have paid enough National Insurance contributions during their working life.

I used the government online estimator which says that I’ll get (roughly) £110 a week as a state pension in 2027 when I’ll be almost 67 years old. Even if that amount is inflation-adjusted, it isn’t worth very much today – so I think I can safely ignore the state pension as any kind of a ray of future financial sunshine or hope.  It might pay for an occasional luxury in my old age, but it’s clearly never going to be the backbone of my retirement plan.

As ever, Wikipedia has a pretty good summary about the different kinds of UK pensions available.

I’m mostly interested in what’s available to the self-employed and, if the state pension won’t save me (and I never thought for a moment it would), what other option are available to me?

It seems like a Self-Invested Personal Pension Plan (SIPP) or Personal Pension Scheme (PPS) are the most likely candidates – although that’s currently the sum total of my knowledge.

Having pored over both those Wikipedia pages, it seems the first thing I need to do is choose and IFA (chapter 1.1) to advise me. It’ll be the (devil in the)  detail of current tax legislation that’ll decide what makes sense and what doesn’t – and there’s no point me guessing when it’s someone’s job to know and advise me.

When I find an IFA and get some pension-specific advice, I’ll let you know.