Reader Writes:
Do you have a view on the best way to save for retirement? Is it a pension or is it an ISA, for example?
The differences between the two are really quite simple but the changes to personal tax allowances in April make a pension much more attractive than ever before. More on that in a moment.
Let’s look at what a pension and ISA actually are. I have often heard customers saying that ISA is good or is bad. Presumably this is referring to either charges or performance. The truth is that an ISA or pension is one of the most efficient ways to save money. Both are simply wrappers that determine the tax position of what is inside the plan. Naturally if inside the pension you hold bad funds, or alternatively the charges are high, it doesn’t stand that the pension/ISA is bad, simply that the content chosen is bad.
Both an ISA and pension grow virtually free of tax. There are a few key elements that separate them. On the entrance to a pension you will immediately receive tax relief on your pension at your highest rate whereas with an ISA you will not. On exit, the pension will be taxable whereas the ISA will not. Both the income and capital gains will be completely free in an ISA when you decide to take it.
From an accessibility point of view an ISA allows you total access at all times to your money whereas a pension only allows access from age 55. The pension will not allow you access to 100% cash, restricting it to 25% of the value of the fund at retirement. This is often a sticking point with many people, as the feeling of a lack of access is hardly motivating for you to consider saving for the next 25 years.
An ISA doesn’t actually provide you with an income at retirement; rather it allows access to capital from which you can take an income. A pension however provides an income which is guaranteed if taken correctly.
Undoubtedly the key benefit of the pension is the tax relief on the contribution at entry and it’s very difficult to ignore, and warrant any other type of saving over it. Let’s face it, a typical building society today will pay around 6% per year. A pension contribution of £100 for a basic rate tax payer will mean that it only costs £78 after tax relief. For a higher rate tax payer the net cost is £60. This has the effect of a guaranteed growth of over 28% for the basic rate tax payer, and 66% for the higher rate tax payer – the equivalent of over ten years in the building society, but overnight.
I normally say that the Gord (Gordon Brown) giveth and he taketh away, and prior to becoming prime minister he giveth, as he made a commitment to raise the personal allowance for pensioners over the next few years. By 2011/12 the personal tax allowance will be £9770 for an over 65 year old, and £10,000 for an over 75 year old. This will give an amazing opportunity to receive up to £20,000 per year per couple tax free. 1
It is an area that could easily be missed by many, as all too often couples fund pensions on the working spouse which has primarily been the man. This would mean that his personal allowance would be used up but not hers. This could effectively be a gift back to the revenue of £2200, which doesn’t need to happen. I would recommend immediately that pension contributions are used for a spouse where they are not already being used. Care should be taken to try and ensure that a husband and wife’s relevant pension funds are broadly equal, to ensure they use up as much of their respective tax allowances. Remember also that a retired individual who earns over £20,900 in 2007/08 will be penalised by having their age allowance reduced – another reason to keep funds balanced between spouses well after the personal allowance has been taken care of.
For advice on retirement planning or if you have a query call Peter on 0800 0112825 or e-mail info@wwfp.net and take a look at our section on Pensions.
1 Source: Budget 2007
Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorised and regulated by the Financial Services Authority. ‘The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.’
Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made.
The above represents the personal opinions of Peter McGahan.
All information is based on our understanding of current tax practices, which are subject to change.
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