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Pension or Isa? Or both?

INVESTMENT GUIDE: Pensions may be the bedrock of your retirement planning, but Isas are your secret weapon
April 17, 2008

Despite the widely held belief that anyone who wants a comfortable retirement should take out a pension, the argument in favour of pensions for long-term savings is not clear cut. If someone tells you that pensions are without doubt the best option, then they probably have an expensive pension to sell you.

Isas also have benefits and, in some cases, should be the preferred savings vehicle. In fact, it is probably best to hold a mixture of pensions and Isas, plus cash and other investments.

Pensions and Isas are tax wrappers. With some forward planning using both wrappers, it is possible to make income tax in retirement a voluntary system from which it should be possible to opt out.

You can use both to invest in a portfolio of stocks and shares for long-term investment growth. The investments held inside are treated the same: there is no liability to income or capital gains tax, except for a 10 per cent non-reclaimable tax credit on dividends.

The important difference is the tax treatment when money goes into and comes out of the wrapper.

It's basically a toss up between tax upfront (Isa) or tax on the way out (pension).

Contributions to Isas are made out of taxed income, but withdrawals are free of tax. In contrast, the money paid into a pension gets full income tax relief, but income taken from a pension is taxed.

For every £100 paid into a pension, a basic-rate taxpayer contributes only £80 with the government topping up the balance. Higher-rate taxpayers only pay £60 for every £100 invested. In effect, they pay in £80 but can claim back a further £20 through their tax returns (unless they are contributing through their employer's scheme, in which case all tax is dealt with through PAYE).

Although the income from a pension is reduced by tax, there is a rule that helps ease the tax burden: you can take up to 25 per cent of your pension fund as a tax-free lump sum on retirement and the remaining 75 per cent is used to secure an income for life, typically using an annuity.

Whether you choose to use a pension over an Isa depends on how much you earn and your tax status.

Many taxpayers who pay higher-rate tax during their working lives find themselves paying only basic-rate tax in retirement. For them, pensions work very well. However, if you are a basic-rate taxpayer, you may be better off contributing to Isas.

Jason Witcombe, an independent financial adviser at Evolve Financial Planning says: "For those who do not pay higher-rate tax, there is an advantage in making any additional savings into an Isa. Like a pension, the money can be invested into equities which, over the longer term should outperform cash and fixed interest assets, but at retirement the fund could be converted to fixed interest and any income would be tax-free."

To be a higher-rate taxpayer in retirement you need to earn more than £41,435. For a 65-year-old man to buy an inflation-protected annuity greater than this, he would need a pension fund of around £900,000. Assuming he takes the 25 per cent tax-free cash, this means he would roughly need a total pension fund of £1.2m to be a higher-rate taxpayer in retirement. For most people, this level of funding is not achievable.

Ed Green, financial planning manager at Chartwell Private Clients, says: "If a higher-rate taxpayer can be a basic-rate taxpayer in retirement, then pensions win hands down."

A change to the treatment of retirement savings has tipped the balance further in favour of pensions. This year the over-65s personal allowance has gone up to £9,030, a big increase from £7,550 in 2007-08. This limit will the rise to £9,770 by 2011-12. Laith Khalaf, pensions analyst with Hargreaves Lansdown, says: "A couple can now get almost £20,000 tax-free income in retirement. From a financial planning point of view, it makes it important to share pension contributions further between husband and wife."

Even if your spouse does not work or earn an income, it is possible to contribute £3,600 a year to a pension on their behalf and still benefit from upfront basic-rate tax relief.

According to Hargreaves Lansdown, a higher-rate taxpayer, who will pay higher-rate tax in retirement, may be better served by investing in the pension of their non-earning spouse. A 40-year-old basic-rate taxpayer, saving £250 a month, could be £1,000 a year better off in retirement just by making the investment in the name of their non-earning spouse.

LEAVING AN INHERITANCE:

Most people think the ability to leave Isa assets as an inheritance is a strong argument in favour of Isas. On death, the assets held in Isas fall into your estate and can be passed on to your spouse, children and any other heirs.

In contrast, the HM Revenue & Customs has gone out of their way to ensure that once retirement has been reached, pension investors cannot pass on any more than a token amount as a capital sum to inheritors (except for a spouse). The cumulative tax charge levied on non-spousal or dependant death benefit through alternatively secured pension is 82 per cent.

The situation before retirement is different, however. Mr Khalaf explains that pension benefits fall outside your estate if you die before taking benefits. Before retirement, a private pension can pay out the full value of an investor's savings, plus the tax relief granted on the contribution; and this lump sum will normally be free of inheritance tax.

MONTHLY CONTRIBUTIONS REQUIRED FOR A TARGET PENSION:

Target income at 65£1,000£2,000£5,000£10,000
Starting ageContribution required
20£20£40£95£190
30£30£60£150£300
40£50£100£250£500
50£100£195£490£980
60£340£680£1,700£3,400

Projections are based on investment growth of 6 per cent net of charges; contributions increasing at 2.5 per cent a year; inflation of 2.5 per cent a year. Source: Hargreaves Lansdown

PERSONAL ALLOWANCES:

Tax yearOver 65sOver 75s
2007-08£7,550£7,690
2008-09£9,030 £9,180
2010-11£9,500£9,700
2011-12 £9,770£10,000
Sources: HMRC, PBR 2007, Budget 2007