In a climate of uncertain investment returns and with worries persisting over which company - or country - might go bust next, investors could be forgiven for feeling helpless when it comes to constructing their portfolios.
But something they can control to some extent can be identified using just three little letters: T, A and X. And its management could save them a lot of money. Tax is not sexy, but investors can, and should, make sure their portfolios are as tax-efficient as possible.
They can't do much to prevent their investments dropping in value by 5% on a bad day in the markets, but a 10% or 20% hit from the taxman is avoidable. Step forward two tax-efficient investment wrappers: ISAs and pensions. The range of investments you can hold in them is broadly similar, so which one you should opt for depends on your own unique circumstances.
How do they differ?
For most people, the first port of call should be an ISA.
Contributions to an ISA - a cash ISA or the stocks and shares version - are made from money that has already been taxed, and if you invest some of this in an ISA, you won't need to pay income tax or capital gains tax (CGT) on returns.
So for example, a basic-rate taxpayer won't have to pay 20% income tax on cash ISA interest, as they would on savings account interest. Similarly, if they invest in a stocks and shares ISA, they will avoid paying the 18% or 28% CGT on any investment gains above the £10,600 tax-free allowance.
Investors are free to deposit and withdraw money whenever they want, and there is no tax to pay when they do so. For this tax year, the maximum amount of money investors can stuff into an ISA is £10,680 (of which £5,340 can be in a cash ISA). From 6 April, the allowance will rise to £11,280 for the 2012/13 tax year.
Pensions, on the other hand, get tax relief upfront. So for a basic-rate taxpayer, £800 in your hands now will become a £1,000 investment in a pension. If you are a higher-rate (40%) taxpayer, you get £1,000 in the pension and a £200 tax rebate on top. Taxpayers earning above £150,000 will benefit from 50% income tax relief.
The maximum amount that can be put into a pension each year is £3,600 if you don't have an income or your total taxable income (up to £50,000), whichever is greater. The tax treatment on pension investments is the same as with ISAs. In both cases, the 10% tax credit on UK dividend income cannot be reclaimed by the ISA manager or pension administrator.
Pensions versus ISAs: at a glance
- Tax relief upfront
- You can't access your money until the age of 55
- Each year, you can put up to £3,600 in your pension or your total taxable income (up to £50,000), whichever is greater
- Tax relief on interest earned
- Money can be withdrawn at any time unless you've locked your money in
- For this tax year, investors can stuff £10,680 into an ISA (of which £5,340 can be in a cash ISA). From 6 April this rises to £11,280
Sarah Lord, managing director at Killik Chartered Financial Planners, adds: "Due to this tax credit, ideally an investor should not hold investments that generate UK dividend income, or minimise them and, instead, look to growth investments." But restrictions apply on when you can take money from a pension, and this money is taxed, while ISA withdrawals aren't.
You have to wait until retirement – at least age 55 from April 2010 – to get money out of a pension. Even then, you can only withdraw a quarter as a tax-free lump sum; the rest must eventually be used for a lifetime income. So the sheer flexibility of ISAs and the fact that the government rarely meddles with them makes the ISA a straightforward and efficient tax shelter.
In contrast, the government likes to alter the tax relief on pensions. Dennis Hall, founder of Yellowtail Financial Planning, points out: "The problem for the government is that, where it has given 40% or 50% income tax relief, it rarely collects that rate of tax at retirement, as many higher-rate taxpayers find that a greater proportion of their retirement income is taxed at the basic rate."
For young people saving for something specific, such as a house or a wedding, an ISA is undoubtedly more useful than a pension.
Which are better?
There are other situations where ISAs might be more useful than a pension, even where retirement income is the ultimate goal. John Lawson, head of pensions policy at Standard Life, comments: "One such situation is where basic-rate taxpayers expect to pay higher-rate tax in the future.
"Saving up in an ISA while you are a basic-rate taxpayer and transferring your ISA savings into a pension when you become a higher-rate taxpayer means you maximise the amount of pension tax relief you get."
In terms of saving for retirement, both ISAs and pensions can be used - the choice often depending on personal preference.
An ISA can be easier to use, as there are no restrictions on when or how to withdraw the money. However, despite complex pension rules, a pension can be a better bet, as it enforces saving discipline until retirement (there's no raiding the pension to pay for an exotic holiday in your 30s).
It is also a wise choice if you have the option of a workplace pension to which your employer contributes. Not signing up to such a pension would be like throwing away extra salary.
Martin Bamford, managing director at financial planners Informed Choice, sums up the age-old conundrum of ISAs versus pensions neatly: "The decision will depend on your financial objectives. ISAs provide easier access to your money. With a pension, you have to wait until your 55th birthday before you can access a quarter of the pension fund as cash. The balance is used to provide retirement income."
This article first appeared in our sister publication Money Observer