Pensions v Isas: What's the best way to save for retirement?
The major attraction of pensions is that the money you pay in is topped up by tax-relief, meaning a basic rate taxpayer's contributions are boosted by 20%, a higher rate taxpayer gets a top up worth 40% while additional rate taxpayers get 45%.
However, because they are designed specifically for retirement they aren't as flexible as other savings vehicles. This means you won't be able to get your hands on the money until you are 55. Strict rules have also governed what you do with the pot of cash when you do eventually retire, however this is all set to change following announcements made in the 2014 Budget which should effectively bring to an end the need to purchase an annuity.
Isas don't get the upfront tax relief that pensions enjoy, however, unlike retirement savings plans, there is no tax to pay when you cash them in. With pensions only 25% can be taken as tax-free cash so you'll have to pay income tax on the remainder (with the whole lump sum being taxed as income in that year).
Isas were also given a boost in the 2014 Budget. In July 2014 a new, 'nicer' Isa, was introduced, with a bigger annual allowance of £15,000 a year which can be spread across cash and stocks and shares in whichever way you choose. Unlike pensions you can get to your money whenever you like.
So with these pros and cons in mind, which vehicle will net you the biggest retirement pot?
Basic rate taxpayers
Figures from Hargreaves Lansdown show that a basic rate taxpayer with a £15,000 investment in an Isa would have £34,725 after 25 years (assuming 6% growth a year) but if that money had enjoyed upfront tax relief in a pension it would have been worth £43,406.
However when you come to take cash from your pension, anything after the first 25% will be liable to income tax. For somebody paying 20% tax this would bring their pension's value down to £36,895 and £30,384 for a higher rate taxpayer if they were to cash the whole pot in.
So basic rate taxpayers seeking to make large cash withdrawals (enough to bring themselves up a tax bracket) could be better off saving with an Isa. That said, if they were to take the cash out gradually - to prevent them being dragged into a higher tax bracket – the overall tax they pay would be reduced.
Higher rate taxpayers
But while pensions will typically be better for those who pay the basic rate of tax while working, pensions are streets ahead of Isas for those workers who pay the higher rate of tax and get 40% tax relief on their pension contributions.
A 40% taxpayer, paying £15,000 into an Isa would still get £34,725 after 25 years, but thanks to that higher tax relief on contributions they'd end up with a £57,875 in a pension. Of course they would be liable to income tax when they cashed it in, but an investor who cashed in the fund in one go and became an additional rate tax payer in that year (which from a tax point of view would not be very sensible) would still end up with £38,342.
So while the combination of tax efficiency and flexibility make Isas a great way of saving for medium-term goals such as a loft conversion or university fees, most people will end up with a bigger retirement pot if they save for it in a pension. This is especially so if you are in a workplace pension and your employer makes contributions on your behalf.
Laith Khalaf, head of corporate research at Hargreaves Lansdown, says: "Pensions win the pure numbers game, which isn't surprising given the head start they get from up-front tax relief, and the fact 25% can be drawn as tax-free cash. The exception is basic rate taxpayers who draw their whole pension as a lump sum, and so end up paying 40%, or even 45%, tax."
While these savers could potentially land themselves with a big tax bill, that liability could be reduced substantially by leaving the fund in the tax-sheltering pension and only taking money for income as and when it is needed.
Khalaf adds: "People need to think about the tax efficiency of pensions versus the flexibility of Isas. Retirement savings should predominantly be in pensions but once they start being cashed in they can think about recycling that money back into Isas in retirement."
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.