Pensions and ISAs square up to each other
Pensions still provide the foundation of retirement planning. Not only are they very tax-efficient investments, since the changes to the pension rules introduced in April 2006, it is now possible to build a substantial pension fund of up to £1.6 million without tax penalties.
Moreover, because pension funds cannot normally be accessed until the age of 50 (55 from 2010), they impose a useful element of financial discipline on investors. Pensions also buy the security of an income for life no matter how long you live or what the markets do. To compliment your pension planning you should also consider making use of your annual tax-efficient Individual Savings Account (ISA) allowance, currently £7,000, which will increase to £7,200 in April this year. The best balance between utilising the two for individual investors will depend on different factors, such as age, tax status before and after retirement, and whether you own other income-producing investments, such as property.
It’s worth remembering that the key to a prosperous retirement is the quality and performance of the investments in them, not just the tax efficiency of the wrapper. Pensions and ISAs are both tax wrappers, and money held within them receives exactly the same treatment. There is no income or capital gains tax liability, except for a 10 per cent non-reclaimable tax credit on dividends. The key difference between them is in the tax treatment of what goes into and comes out of the fund.
ISA contributions are made out of taxed income, but all withdrawals are free of tax. In contrast, the money paid into your pension gets full tax relief, but the retirement income you eventually receive will be taxed at your then marginal rate.
Although the final pension payout is reduced by tax, there are several important considerations that help to ease the impact of tax on pension income.
With a pension you can take up to 25 per cent as a tax-free lump sum. However, the remainder is typically used to buy an annuity, which will provide a secure but taxable income for the rest of your life.
Most investors receive lower incomes, and therefore pay less tax, in retirement than they do during their working lives, so there is a tax gradient that works on pension investors’ behalf. Many taxpayers who were in the higher-rate bracket during their working life therefore find themselves paying only basic-rate tax on retirement. Pensioners also receive a more generous tax-free allowance each year, known as the age-related personal allowance. In the current tax year it amounts to £7,550 for over 65s and £7,690 for over 75s. The Government has promised to increase it to a maximum of £10,000 over the next four years, so couples will receive up to £20,000 of tax-free income in retirement.
There are other factors to bear in mind that strengthen the argument for making use of your ISA allowance every year alongside pension contributions.
Although pensions work extremely tax-efficiently for long-term saving, the money in them cannot be touched until the age of 50 at the earliest. That is a valuable safeguard for your retirement income, but it means you need other sources for emergencies or interim expenses. If you required money before retirement, you could cash in some or your entire ISA portfolio without tax penalties.
The relative advantages of ISAs and pensions in this respect depend on whether you die before retirement or after. ISA assets become part of the investor’s estate on death and may be subject to inheritance tax, but they can be freely left to family or friends.
Pensions are an ideal asset for anyone who might die before retirement, because not only do they pay out in full but the lump sum is normally free of inheritance tax. However, it is a different story after retirement. If you opt for an alternatively secured pension, where you continue to draw an income from the pension fund, rather than buying an annuity with it, then unless it continues paying out to your spouse or dependent children, it will be subject to cumulative tax totalling 82 per cent on your death.
The age-related personal allowance is an increasingly generous tax break for pensioners on lower retirement incomes. But it is capped by an upper income limit (currently £20,900 per person). Once your total retirement income exceeds that level, the higher personal allowance begins to be clawed back at the rate of £1 for every £2 above the threshold until it is back in line with the standard allowance of £5,225. Income from ISAs is not declared to HM Revenue & Customs, so by building an income-paying ISA portfolio, you may be able to keep income from pensions and other taxable sources below the threshold.
Levels and bases of, and reliefs from, taxation are subject to change.
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