Are ISAs a better alternative to pensions?
Your choice of tax-efficient vehicle is one of the first dilemmas of saving, and often the choice is between an individual savings account and a pension.
In reality, most people should spread their savings between the two, so they have funds they can access if they need to in an ISA, while also taking advantage of the full income tax relief on pensions.
ISAs are certainly more flexible in several ways and this has made them extremely popular in recent years, particularly as distrust of pensions has grown. A major grouch about pensions is that they must be converted into an annuity (a monthly payment plan) or accessed through an income drawdown plan.
Buying an annuity is currently dreadful value and looks set to remain that way as the Bank of England is committed to keeping interest rates down and life expectancy continues to rise. On average, it takes someone drawing an annuity some 20 years just to get their money back, although enhanced rates are available for those who shop around, especially if they have a medical condition.
For a 50% taxpayer, however, the tax relief on pension contributions is a serious uplift - after all it means that you can make the maximum £50,000 annual contribution for just £25,000.
A pension is also attractive for the many taxpayers who pay higher-rate tax during their working lives and then only pay basic-rate tax in retirement. As a rough rule of thumb, you will pay higher-rate tax in retirement if your pension fund exceeds £1.5 million at today's rates, assuming you take your entitlement to 25% tax-free cash.
If you do expect to pay a higher rate of tax in retirement you should also max out on ISAs first with the full £11,520 allowable annual investment, which will be tax-free on disposal and have no bearing on your age allowance (the income you can be paid before paying tax in retirement). The pension income can then be set against the age allowance, which this tax year is £10,500 for the over 65s rising to £10,660 at age 75.
In practice, if you hold a mixture of pensions and ISAs, with careful forward planning it may be possible to make considerable tax savings by using them at different times.
Start with ISAs and move to a pension
Young people on an upward career path might benefit from saving in ISAs initially, and later transferring the accumulated sum to a pension when they start paying higher-rate tax so that at that juncture they can receive higher-rate tax relief on their entire accumulated pot, says Standard Life head of pensions policy John Lawson.
"For example, if you saved £5,000 annually into a pension for 20 years, paying basic-rate tax for 15 years and 40% for five, you would have a lump sum of just under £193,459, which would buy a pension of £11,215. This is based on past capital growth of the FTSE All-Share index," explains Lawson.
"However, if you saved into an ISA for 15 years and then began to siphon this money into a pension once you had paid higher-rate tax, you would have £236,298, making you £42,839 better off without saving a penny more. This would buy you an extra £2,488 worth of pension income at least - possibly more, depending on your age and state of health."
Sharing pension contributions between a couple can help as this doubles the age allowance to £21,000 of tax-free income in retirement. Even if one spouse does not earn anything, it is possible to contribute up to £2,880 a year into a pension on their behalf which becomes £3,600 with automatic tax relief.
Employer pension contribution
The other big benefit of a pension is that employers often contribute and this will be mandatory in future as the government has legislated that every employer should offer a pension scheme to its staff, starting with big employers this October and smaller firms over the next few years.
Initially these will be minimal, requiring employers to contribute 1% of an employee's salary to his or her pension plan, rising to 3% by 2017. In addition, many large employers offer to match additional member contributions, which is effectively a pay rise.
If you elect to have a pension through a salary sacrifice scheme you can also avoid paying national insurance. For a basic-rate taxpayer this means tax relief at 20% on the contribution, plus 11% national insurance saving. Some larger employers will pay into ISAs on behalf of their employees as part of a flexible benefits package, but it is not tax efficient.
Many investors think ISAs trump pensions in relation to inheritance tax because on death, the assets held in ISAs fall into your estate and can be passed on to your dependants.
In contrast, HM Revenue & Customs takes a tough stance on attempts to pass on pension funds to beneficiaries and levies a cumulative tax charge on dependant death benefit through drawdown at 55%. And if the pension has been converted into an annuity, the insurer keeps anything left in the pot when the policyholder dies.
If you die before retirement, however, pensions are actually more attractive than ISAs because normally the money is paid 100% tax-free to your estate or spouse and, as most pensions are written in trust it is not included in any inheritance tax calculation.
There are also other considerations that require some crystal-ball gazing, such as whether current tax attractions will continue to exist in their current format or whether you believe the government will not be able to resist the temptation to tamper with them. It is probably only a matter of time before tax relief at the top rate will be abolished and the 25% tax-free cash could also be in peril.
Minimum retirement age
In addition, who is to say that the minimum retirement age will not again be raised from its current age 55? It was last hiked from age 50 in 2010 and the government is increasingly concerned that life expectancy is continuing to escalate.
Similarly at the moment a pension pot pre-retirement will not affect most means-tested benefits, such as income support, but not long ago pension savings were protected in bankruptcy, and this has already been changed.
Personal pensions and ISAs can invest in a wide range of funds while ISAs and a slightly more sophisticated type of pension called a self-invested personal pension can also invest in stocks and shares. "Clearly both have their attraction when building long-term wealth in that although ISAs don't offer initial tax relief, they do grow virtually free from tax and you can take income or withdrawals in the future free from income and capital gains tax," says Steve Wilson, director at Alan Steel Asset Management.
One neat strategy is to invest your ISA in high-growth assets such as equity funds until retirement and on retirement to switch it to fixed interest such as cash and bonds, that will pay a tax-free income.
SIPPs are useful for individuals with several pensions from previous jobs looking to consolidate their funds into a single manageable pot. They are available in two versions - SIPP Lite, a cheap and cheerful version primarily for investing in funds, and a full SIPP for financially astute investors who want to manage their own portfolios. Full SIPPs can invest in an array of sophisticated assets such as structured products, derivatives, hedge funds, traded endowments and, most significantly, commercial property.
Commercial property is a popular option for business owners who want to buy their business premises tax-efficiently within their pension. Tax relief on contributions boosts the capital available to buy the property, and it's also possible to borrow up to 50% of the fund value.
The big restriction for investors looking to invest in shares in an ISA remains the ban on junior companies that trade on the Alternative Investment Market (Aim). However, SIPPs can invest in Aim shares.
For higher-rate taxpayers with a taste for start-up companies, and higher risk, there are venture capital trusts that offer income tax relief of 30% on a maximum investment of £200,000 per tax year when you buy newly-issued shares. These are for investors looking for potentially higher returns and can stomach the higher risk of funds that invest in smaller companies not listed on the stock exchange.
What's right for you? Pros and cons of ISAs and pensions
- The most you can put in to an ISA is £11,520 in the 2013-14 tax year, and up to £5,760 of this can be in cash.
- You pay no income tax on withdrawals from an ISA and any profits from investments are free of capital gains tax.
- The most you can put in to a pension is currently £40,000 a year and your accumulated pot must not exceed the lifetime allowance, which is £1.25 million (excluding state pension).
- The money you pay into a pension receives a tax rebate, with your contribution rounded up automatically if you are a basic-rate taxpayer or non-taxpayer.
- A pension fund grows tax-free but is taxed at your highest marginal rate when you take the benefits. You can usually take up to a quarter of your pension fund as a tax-free lump sum.
- The compounding effect over the years on the tax relief element you've received in your pension is one of the major advantages of a pension over an ISA.
This article was written for our sister publication Money Observer.
A tax-efficient way of receiving staff benefits, where an employee agrees to forego a proportion of their salary for an equivalent contribution into their pension scheme or in exchange for company car, gym membership, childcare vouchers or private medical insurance. A salary sacrifice scheme is a matter of employment law, not tax law, and is often entered by an employee who is about to move into the higher 40% tax bracket.
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. To qualify for the state pension, individuals need 30 years’ of full NI contributions.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
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.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
A person (or business) unable to pay the debts it owes creditors can either volunteer or be forced into bankruptcy – a legal proceeding where an insolvent person can be relieved of their financial obligations – but loses control over their bank accounts. Bankruptcy is not a soft option. Although it may wipe the financial slate clean, it is extremely harmful to a person’s credit rating (it will stay on your credit record for six years) and will adversely affect your future dealings with financial institutions. Bankruptcy costs £600 paid upfront.
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.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
Alternative Investment Market
AIM is the London Stock Exchange’s international market for smaller companies. Since its launch in 1995, 2,200 companies have raised almost £24 billion listing on AIM. The market has a more flexible regulatory system than the main market and can offer tax advantages to investors but its constituents are a riskier investment than bigger companies listed on the main market.