Do you have a little cash to invest, but find that overwhelming financial jargon stops you from investing? Do you REALLY understand the difference between retirement funds, tax free investments and unit trusts, and why you should invest in one and not the other?

In today’s episode, I demystify all of it!

Show notes:

• [01.49] The challenge with investment jargon

• [04.51] Types of investments

• [08.07] Tax and your investments

• [14.35] Two other ‘wrappers’ of investing (alongside the tax ‘wrapper’)

• [16.45] Bringing it all together

Quotes

“If you keep listening to what everyone else thinks is best and not understand it for yourself, you may choose the wrong investment type for you.” – Lisa Linfield

“It’s all about freedom of choice. You basically have two camps: a totally flexible investment on the one hand and other investments that have some great features but have different kinds of restrictions on the other hand.” – Lisa Linfield

“If you’re self-investing and the government gives you back tax to accommodate for your retirement investing, make sure you go immediately and invest the tax they give you into a flexible investment so you’ve got money to pay the tax when it comes to retirement.” – Lisa Linfield

“Capital gains in almost every country is way lower than income tax.” – Lisa Linfield

Related posts and episodes

• Which one’s best for you – Retirement funds, Tax Free investments, Endowments or Direct?

• Investing Tax free!

• Optimising tax on your investments

• The decision tree you need to choose your investment

• The four foundations of investing

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TRANSCRIPT

When people talk about Retirement Funds or 401Ks, Tax Free accounts or ISA's in the UK, and Roth IRAs in the US, Endowments, and "normal" investing such as mutual funds, unit trusts and shares, do you REALLY understand the difference between them and why you should invest in one more than the other?

And if you have "spare money" to invest, do you automatically assume it should go into your retirement funds?

In today's episode, we'll demystify this

Now I know all any of us really want is to put our money in the right investments so that we can make it work hard for us, so it can generate tons of money babies that mean we don't have to work because it's working for us, RIGHT?

But yet, when you have a spot of cash to invest, you have to navigate this unbelievably complicated landscape of investment jargon to just try and understand what TYPE of investment you want to make, and that's BEFORE you actually have to choose the underlying investment of shares or bonds, and which type of fund you want to buy.

And it makes us all just want to curl up in a ball and hide under the table. So we end up not investing, or holding our breath and choosing something and hoping for the best - adding to our underlying anxiety as to whether we're investing our money correctly.

That anxiety and all those confusing terms is because the investment industry can't explain to us in words we understand, what on earth they mean. It's like they insist on speaking greek to us knowing we speak English.

So, like you, when I first started investing, I had to learn what all the jargon meant, and then, I had to shake off all the things friends told me at dinner parties, and the World Out There told me as I grew up, and work out what the right thing to do REALLY was.

I want you to think of it a little like going to a wine tasting or in my case, Gin or Ice-cream tasting as a complete newbie.

You're sat down at a table with a whole bunch of other chattering humans and blind folded and asked to taste 10 different wines and say which one is best.

As you begin to taste, you hear the person to your right say to you that number 3 is absolutely the best because it has leather aromas and a tingle at the back of their palate.

And for you, you're thinking, goodness, which one was Number 3 again, and how on earth does he know what a leather saddle tastes like... and if you recall correctly, you thought that one was so acidic it might have burnt a hole in your tummy.

As the lady across from you spouts on about smoothness and fruitiness, with hints of pomegranate, you find yourself wondering how on earth they put pomegranates into wine.

At the end of the day, you think wine number 7 was the best for you.

When you take your blindfold off, you realise that the lady and the gent who were talking about leather and pomegranates were in fact world experts... so you assume their taste is clearly the best... and despite wanting and needing wine number 7, you find yourself buying boxes of wine number 3 + 10... in addition to your number 7.

When you come finish your stock of Number 7, you decide you need to replenish it - but you have no idea how to narrow down the gazillion choices in the bottle shop and find that right one, or some similar to that style you like.

So that's what I'm going to help you do. understand the main reasons these things are different, so that you know what and WHY you should choose something to invest in

There are three main differences between all of them

1. Tax

2. Amount you can invest

3. When and how much you can withdraw from your investment

At the heart of it, it's about FREEDOM of CHOICE. A totally flexible investment on the one hand, vs investments that have restrictions on the other.

The most autonomous or free way you can invest is when you invest outside of any of the structures.

You either buy a share or fund with the money in your bank account, and can sell it at any time you want.

I call this Flexible investing, but some in the industry call it Discretionary Investing because you have the discretion or choice as to how you want to invest.

And when it comes to what you invest in, it may be helpful to quickly cover the same term that has different names in different countries. Funds, as they're known in the UK, is when an investment manager chooses a group of shares or bonds, and puts them together in a basket, and you can buy a piece of that fund or basket of investments. They are called unit trusts in South Africa and Mutual funds in the US... and in Episode 179 I dealt with the question of whether you should buy funds or go for individual shares and why (spoiler alert, stick with funds)

So the first type of investment you need to have anchoring your investments are flexible, free standing investments.

As I get into all the other types of investments, you will start to see why one of THE biggest mistakes I see people making with their investments is by NOT having enough free standing investments

So let's turn our focus to the more inflexible or rules based investments.

As I said, there are three main sets of rules that these types of investments have

1. Rules about Tax

2. Rules about the amount you can invest

3. Rules about the amount you can withdraw and when.

In the investment industry, we call these rules "wrappers" because the rules wrap up the investment inside it.

To a greater or larger extent, you could have the same underlying fund you invest in, like the MSCI world index, in either a retirement fund, a tax free fund or an endowment... the difference between them would be the set of rules that govern them.

So let's start with tax.

There's three places you pay tax:

1. on your income,

2. on the investments whilst you're invested

3. on the growth on your investments when you cash them in

Retirement Funds - either those you self invest in, or ones your employer invests in on your behalf - are the only only one that you are allowed to put your money in without paying income tax.... which means that you can start with a whole lot more.

So if you earn 100 and your income tax rate is 25, most of us will receive 75 into our bank account.

Let's say you wanted to invest 15 for your retirement...

When your company takes money from your earnings and invest it into your retirement fund, of the 100 you earn, they first take 15, leaving you with 85 and then the government taxes you on 85 and not the full 100.

If you personally invest the 15 in a retirement fund from your after tax money in your bank account, you then claim the tax back from the government on that 15.

So the reason people recommend you invest in a retirement fund is that because you can invest more money as it's pre-tax… which means that when your investments grow, they're growing off a bigger base.

Here's the challenge…

Governments NEVER miss out on their tax.

So when you need the money in retirement, they then tax you at BIG income tax rates... because they always get their pound of flesh.

So here's the problem with having all your money in a retirement fund.

I had two clients who retired at almost the same time with almost the same amount of total investments.

But one had all of their money in retirement funds, and the other had half in retirement funds and half in flexible funds.

Let's say they had 1m invested.

And investment best practice says you can draw 4% per year... 40k in this case.

Because they hadn't factored in tax on their retirement money, they both assumed they had 40k per year to invest.

After 40% tax, the one with all their money in retirement funds had R24k per million, and the one with flexible investments had R35k.

Real life, real story... one about totally underestimating the fact that the 4% rule is 4% BEFORE tax... and the mental maths underestimating tax.

So the first thing you need to keep in your mind when it comes to investing in retirement funds is that you WILL be taxed at high income tax rates when you draw.

And, if you're self-investing and the government gives you back your tax into your bank account, make sure you invest it so you can pay the tax later on!!!!!

So we've dealth the first major tax difference, which was that for retirement funds, unlike all the others, it's the only one that you invest before income tax.

The rest you invest after income tax.

But the second piece of tax we discussed was tax that's paid while you're invested

There are two main types of tax - Dividend tax and interest income tax.

What's important to know is that BOTH Retirement Funds AND Tax Free funds (or ISA's in the UK and Roth IRAs in the US) give you a tax break on investment income - or earning dividends and interest.

And this is BIG. It means that you get the full income to invest on your investments, which means it can grow and grow and grow.

For flexible investments, you will pay dividend tax and you will pay interest income tax - though many countries give you a certain amount of free interest income before you get taxed.

The last tax you pay is when you exit the investment.

Like when you buy a house and sell it, you pay capital gains tax on the amount your house grows, you do for flexible investments as well. But Capital gains in almost every country is WAY lower than income tax, and so it's a very efficient way to draw money when you're retired because the tax rate is so low.

For Retirement funds, as I mentioned, when you draw the money you pay income tax... but for Tax Free accounts, you don't.

Which is why I always say thatthe first and THE MOST important place you should invest is in Tax Free Investment Accounts. Because it's money that lands in your bank account after tax and it has absolutely no tax when you invest it and when you withdraw it. So what you see is what you get.

So here's my question to you… are you maxing out your tax free investment account each year? Even if you have to pull back on your retirement funds?

Make sure your first investment is to your tax free investing account.

So we've covered

1. Tax Rules

The next two we'll whip through…

2. The amount you can invest and

3. The amount you can withdraw

The amount you can invest

When it comes to how much you can put in, These apply to BOTH Retirement Funds and Tax Free accounts.

Because they're giving you a tax break, they don't to lose out on the tax, so they limit how much you can put in.

In some countries they limit the amount per year you can deposit, and in others they limit that AND the total amount you can deposit in a lifetime.

It's so important to be aware of this - because if they limit in the lifetime and you do withdraw ... in the case of Tax Free for example... you may never be allowed to top that up.

It's why I always say Tax Free accounts should be thought of as Retirement funds... for money you put in and leave for retirement... not used as saving for a holiday or deposit on a house.

The British and South Africans got it wrong when they called it a Tax Free Savings account or ISA - individual SAVINGS account. The tax breaks are best for investing, and for investing for a very long time.

So put it first in the Tax Free account and leave it there.

Lastly, the amount you can draw out.

This differs from country to country, but in most there's a cap to how much you can draw as a lump sum and how much you can draw per year.

The reason why governments do this is that they don't want you to spend all your money at once and then live off their social services. They need your money to last as long as possible, so you don't become a burden to the state

So let's recap…

Investing in different types of wrappers without knowing what actually is best for you is a little like buying wine because someone else liked it.

Know what the implications are for you, and why you're choosing something, and you'll be able to find the right thing for you and choose again and again and make the right choice.

Both Retirement Funds and Tax Free investments are great because your money gets to grow tax free - no dividend tax, no income tax

So there's more money in your account to grow or compound.

But, Retirement funds are very expensive in retirement as you pay high income tax rates, so you need a lot more money to retire because of that.

They are also very inflexible, so if you need money in retirement for an emergency or to pay for a big health expense or the new retirement home, you can't access them... you can only draw a certain amount each year.

So it's hugely important that you invest in all types of funds - retirement, tax free and normal investment accounts so that you have flexibility in how you invest and how and when you draw on your money in retirement.

These things are complicated…. But the more you listen, the more you will become familiar with them.