Pensions are seen as the customary approach to save for your retirement, but could there be a better strategy?
When it comes to deciding how you'll plan for your retirement it really is a case of swings and roundabouts. Weighing up the relative merits of each strategy can be difficult, which means most of us end up settling for a traditional pension scheme. But perhaps you haven't yet considered another investment vehicle -- an individual savings account (ISA) -- which could work well for you as a retirement fund.
So which of the two strategies is the most effective in providing for your twilight years? Here are some factors for you to consider:
The Case For Pensions
- The tax treatment of pensions and ISAs is poles apart. With a pension you'll receive tax relief on your contributions at your highest rate of tax. What's more, if you don't earn enough to pay any tax you'll still benefit from basic rate tax relief.
- Your pension will grow in a tax-advantaged environment and you'll be eligible for a tax-free cash sum of 25% on retirement.
- Your employer may be willing to make contributions to the scheme on your behalf. You might also be expected to contribute to qualify for a top-up from your employer. This should encourage a more disciplined savings habit, perhaps investing even more than you otherwise would.
- You can invest almost unlimited amounts into your pension. Under current rules you're permitted to invest up to 100% of your earnings up to a cap of £225,000 (£235,000 in the new tax year.)
- Your pension isn't accessible until you choose to take your retirement benefits. This means you won't be tempted to spend your fund on something far more frivolous!
But.......
- On the downside, income taken from your pension at retirement is taxable at your highest rate of tax. If you're a higher rate tax payer your income will suffer a 40% deduction. Ouch! But if you paid higher rate tax during your working life but become a basic rate tax payer once you retire, the taxman won't take such a large bite.
- The basic rate tax bracket is reducing from 22% to 20% in the new tax year. This means to receive a `grossed up' contribution of £100 with basic rate tax relief, you'll need to invest £80. In the current tax year you only need to invest £78 to get the equivalent amount.
- Most of us will be obliged to purchase an annuity with our pension funds but with persistently low annuity rates on offer these provide comparatively poor value for money.
- There's little opportunity to preserve your pension in the event of your death. Unless you buy an annuity with a guarantee period which determines in advance how long your annuity will be paid for regardless of whether you survive that long or not.
Alternatively you could buy a capital protected annuity where on death the income already taken is subtracted from the purchase price you initially paid for your annuity with the remaining amount refunded. But unfortunately these products aren't widely available and generally provide less competitive rates than standard annuities.
The Case For ISAs
- There's no tax-relief on ISA contributions but your fund will grow tax-efficiently and crucially there's no tax to pay on funds withdrawn from an ISA as it will be exempt from Capital Gains Tax (CGT). You can think of this as the reverse of the tax treatment of pensions. All things being equal, this amounts to the same thing.
- With an ISA you can totally sidestep the need to purchase an income via an annuity and you can simply draw on your fund as you wish, tax-free.
- You can access your funds if required, perhaps in an emergency. But remember once you have used your full allowance in the tax year, if you make withdrawals the fund can't be replenished until you have a new allowance available to you in the following tax year.
- Your fund can be passed onto your dependants in the event of your death, although it will lose its ISA status.
But.......
- There are much heavier restrictions on how much you can invest. This tax year you can save up to £7,000 into a fund which invests in stocks and shares. This limit is due to rise marginally to £7,200 in the new tax year. While that would probably be sufficient for many of us, higher earners may find this limit is just too low.
- By opting for an ISA you may lose out on valuable employer pension contributions.
- You can access your fund whenever you like. While this might give you greater flexibility, it also means your money isn't locked away and you'll need to resist the temptation to fritter.
- There's no guarantee that ISAs will be available forever and legislation could change. However, it's likely if they were ever abolished, a new tax-efficient initiative would appear in their place.
Or A Combination of Both
If you're a basic-rate tax payer with a pretty good chance of becoming a higher-rate tax payer at some time in the future, then it's an excellent idea to save into an ISA first. You can build up a lump sum in the ISA wrapper while your earnings are still subject to income tax at the basic rate.
But once you have sufficient earnings on which you pay higher-rate tax, the perfect opportunity emerges to move your savings into a pension. You won't suffer any capital gains tax (CGT) by closing your ISA, but by moving the sum into a pension you'll instantly qualify for 40% tax relief on that amount. And this is going to be a massive boost to your pension fund.
That said, this only applies as long as you have sufficient earnings in the tax year which are subject to higher-rate tax to cover the amount of the contribution. If you don't have enough earnings on which you pay 40% tax, then you could move money in phases out of your ISA and into your pension over a series of tax years, although you'll need to ensure your ISA allows partial withdrawals.
So that concludes the main factors you need to think about. Remember whichever route you go down, choose an investment fund which is consistent with your attitude to risk and keep an eye out for the charges too. To a certain extent that final decision will depend on your personal circumstances but perhaps it shouldn't even be an 'either/or' question.
I think the best option is to invest as much as you can comfortably afford into pensions and ISAs to get the best of both worlds while taking advantage of all the generous tax breaks.
More: Boost Your Pension For Free! | Five Changes For Your ISA.