THE long-standing debate over whether those planning for retirement should pay as much as they can into their pension or make the most of their Isa allowance has taken on more significance of late due to changes that will affect both of the savings vehicles.
Pensions are changing and higher earners will probably no longer get full income tax relief on pension contributions. But at the same time investors can now benefit from an increased annual Isa limit of £10,200.
So should people consider using an Isa instead of a pension? There is still a widely-held belief that anyone who wants a comfortable retirement should take out a pension, but people are beginning to question their effectiveness as a long-term savings vehicle.
Both pensions and Isas are tax wrappers, but the crucial difference is that with an Isa you pay tax upfront, and with a pension you pay tax on the way out.
Pension contributions attract tax relief – a major benefit, however this will be reduced for top rate tax payers next year, assuming that the coalition government maintains Labour’s plans. Basic rate taxpayers get 20 per cent.
Also, when you take an income from your pension, you can only take up to 25 per cent as a tax-free lump sum, and the remaining 75 per cent is reserved to secure an income for life, usually by buying a standard annuity, taxed at normal income tax rates.
Contributions to an Isa, on the other hand, are made out of net income so there’s no tax relief, but withdrawals are completely free of tax.
“For the great majority of investors, pensions offer a modest tax advantage relative to Isas because of the tax-free lump sum at retirement and because of the relatively generous income tax allowances available to most retirees,” says Tom McPhail of financial adviser Hargreaves Lansdown.
However, Malcolm Cuthbert from stockbroking firm Killik & Co, says that unlike income from a pension, which will always be subject to an individual’s marginal rate of tax, Isas can provide a tax-free income in retirement.
“Funds are held within a tax-advantaged wrapper that are not subject to income or Capital Gains Tax,” he says.
If you are looking for flexibility, Isas once again fare better than pensions, as the money in pensions cannot be touched until the age of 55 at the earliest.
An Isa, however, has no restrictions, and allows you to make withdrawals as and when you need. This also means that if your financial plans change before retirement, you can cash in a portion of your Isa without tax penalties.
“Pensions do offer a tax-free lump sum of 25 per cent, but you can’t access the money until you retire, and there are restrictions on how much income you can take,” says Adrian Lowcock, investment adviser at Bestinvest. “While there is no relief on Isa contributions, the investment can be cashed in at any time, and investors can decide how much to take out from their investments as income or as capital,” he adds.
EARNINGS AND TAX STATUS
The choice between a pension and an Isa also depends on how much you earn and your tax status.
“The trick with pensions is to get a higher level of tax relief than the rate you will expect to pay in retirement,” says Jason Witcombe of financial adviser Evolve Financial Planning. “A basic rate taxpayer who expects their income to rise would be better off paying into an Isa until income exceeds the higher rate tax threshold of £43,875.”
Pensions then become more favourable, he adds, because tax relief of 40 per cent applies.
McPhail says that for higher earners in particular – and for higher rate taxpayers generally – the simple answer for this year is to maximise pension contributions while you can still benefit from the relatively generous tax breaks available.
“From 2011 onwards, for those higher earners who lose their tax relief, the picture will be more ambiguous,” he says. “It will probably still make sense to take advantage of any employer contributions into pensions, but thereafter, Isas may look more attractive. The decision will depend on individual circumstances, with pensions, qualifying life policies, offshore investments and venture capital trusts (VCTs) all offering possible solutions.”
With pensions, everyone can invest 100 per cent of their income each year – subject to a cap of £255,000 – and has a lifetime allowance of £1.8m.
However, Cuthbert points out that the increased limits means a couple can now place £20,400 each year into an Isa.
“The real benefit of Isas is compound interest which means that relatively small regular savings over a period of many years can result in large Isa holdings,” he says. “Investing regularly also smooths out the highs and lows of the market.”
Elsewhere, Neptune Investment Management claims couples may be able to build a lump sum in an Isa which, as the investment grows over the years, may be in excess of the lifetime pension allowance.
But not all agree. “Despite the new Isa limit now standing at £10,200, contribution limits for pensions are much higher than for Isas,” says Nick McBreen of financial adviser Worldwide Financial Planning. “It would be amazing to meet many retail investors who are in a position to fund Isas sufficiently to exceed the pension lifetime allowance of £1.8m. Even with the new Isa allowance, the investment performance to outstrip the pension lifetime allowance would need to be achieved via a very high-risk Isa investment strategy.”
Paul Inkster from Barclays Stockbrokers adds that Isas will generally lag behind on performance.
“Now a couple can place £20,400 each year into an Isa, the portfolio, protected by tax, can quickly grow to meaningful amounts by making regular annual contributions,” he says. “However, with the boost from the tax relief received within pensions, the performance of Isas on a like-for-like basis will always struggle to match that of self-invested personal pensions (SIPPs).”
ISas have their advantages, however for most people, a combination provides the best long-term solution to funding their pension, according to Lowcock.
“That way, you get the best of both worlds: the tax relief on pension contributions with the flexibility and tax-free income generated by Isas,” he says.
Barclays Stockbrokers’ Inkster adds that pensions are complementary to Isas. “Each tax-efficient structure offers different benefits, and for this reason, investors should consider both when structuring a portfolio,” he says.