Pop quiz! Which is bigger - 25% or 20%?
That's a pretty simple question, isn't it? If your boss asked if you wanted a 25% bonus, or a 20% bonus, you know which one you'd pick.
The UK Government has a savings product called a LISA - Lifetime Individual Savings Account. The premise is pretty simple. You pay in up to £4,000 per year and the government will give you a 25% bonus on your payments.
(I'm currently a Civil Servant, but I don't work on LISA. These are my personal opinions.)
Now, there are various restrictions on what you can do with the money - but 25% is basically free money, right? Wrong!
The money you pay in to a LISA comes from your pay cheque. Most people in the UK pay 20% income tax.
So, you pay 20% tax on your income and get back 25%. Net positive, right? Wrong!
This is a massively effective piece of psychological manipulation! You get an identical bonus whether you put the money in a pension or a LISA - but the way it is presented makes it look vastly different.
The choice is:
* 20% reduction in your tax bill, or
* 25% bonus on your money
Let's work it out. Imagine you get a pay rise of £100. You pay 20% tax - that's £20. Your take-home pay goes up by £80.
You decide to invest all of your bonus in a LISA. You get a 25% bonus.
£80 * .25 = £20.
£80 + £20 = £100
Effectively, you get back the tax you already paid!
If you put that £100 in your pension, you'd receive tax relief of 20% - which means it would only cost you £80 from your take-home pay.
But, when I talk to people about their investments and retirement planning, they can't get over the fact that a 25% "refund" is identical to a 20% "charge". That's one of the things which makes the LISA so attractive - it's a a "larger" number than the tax penalty.
It's hard for most people to understand how their pay is calculated. After tax, National Insurance, student loan repayments, and any other deductions, your salary and take-home pay can be radically different.
When someone puts £100 into a pension, their take-home pay goes down by less than £100 - but that fact is often lost in the confusion of personal finance.
It's a beautiful little nudge - and unreasonably effective at helping people to save.
The numbers I've used in this blog are simplified for illustrative purposes. This is not financial advice.