When it comes to tax free saving, investors have two choices - pensions and individual savings accounts (Isas). So which should you make use of first? There is no simple choice, as the two have different pros and cons. Pensions benefit from tax relief and are the obvious route to save for retirement. However, Isas provide tax-free income and are much more flexible.
Ultimately, then, your use of tax wrappers will depend on your own circumstances, but it is likely that using both Isas and pensions will be sensible. As Darius McDermott, of independent financial adviser (IFA) Chelsea Financial Services, puts it: "They're complementary, rather than competing, wrappers."
Tax relief
One great advantage of pensions is that your contributions are topped up at your highest rate of tax by the government: 22 per cent for basic-rate taxpayers or 40 per cent for higher-rate taxpayers. Gains and income within the pension are tax-free. However, income tax is charged on income from pensions, balancing out the tax relief to some extent, although you can take up to 25 per cent of your pension fund as tax-free cash. By contrast, Isas receive no initial tax relief, but gains and income within the Isa are tax-free and there is no tax on income from Isas. In short, Isa money is taxed before it goes in, pension money is taxed when it comes out.
So, assuming you move from higher-rate taxpayer status while contributing, to basic-rate taxpayer status in retirement, the key advantage of pensions tax relief is to boost the tax-free cash element by 40 per cent - or a 10 per cent overall boost.
Tom McPhail, of IFA Hargreaves Lansdown, notes: "For a higher-rate taxpayer who then becomes a basic rate taxpayer, the tax benefits are pretty hard to ignore." The effect of tax relief boosts the overall return on a pension for someone in that position by 39 per cent, compared with the return on an Isa.
Still, Isa income could be used to supplement pension income and keep yourself as a basic-rate taxpayer in retirement (as it does not have to be declared). Justin Modray, of IFA Bestinvest, adds: "The age-related [tax] allowance is a great advert for Isas."
Another option - provided you have sufficient discipline - is to save in Isas as a basic-rate taxpayer, with the intention of moving your Isa funds into your pension when you become a higher-rate taxpayer in order to maximise tax relief.
Contributions
You can contribute up to 100 per cent of your annual income to your pension (capped at £225,000 for the 2007-08 tax year) and can have a personal pension as well as a company scheme. At the same time, you can also take out a pension for a non-earning spouse - or anyone else - with a stakeholder contribution of up to £3,600 a year (including tax relief at the basic rate).
This should help people save more for retirement, as fairly hefty contributions are required to provide a decent pension. For example, someone with 25 years to retirement, who has yet to start a pension, would need to begin saving 30 per cent of their annual income in order to retire on two-thirds of their salary.
In this way, the contribution limits for pensions are much more generous than for Isas. You can only invest up to £7,200 a year in a stocks and shares Isa or £3,600 a year in a cash Isa. You could also take out an Isa for a non-earning spouse, though, doubling your annual investment limit to £14,400.
Risk
So pensions seem the more tax-efficient way to invest. But there is a complicating factor: risk of default. For example, rich people might be advised to diversify away from apparently generous company final-salary schemes in case of default, as government compensation is limited. The Pension Protection Fund limits compensation to 90 per cent of your expected pension (if you are yet to retire), capped at a maximum of £26,050.
Patrick Connolly, of IFA Towry Law JS&P, comments: "If you're in a public-sector scheme, you're as safe as you could be but, in a company scheme, you have to ask whether topping up is the most sensible thing to do - you could be putting a significant amount of your wealth at risk."
In general, though, it always makes sense to contribute to an occupational pension scheme if your employer makes contributions, as saying no would amount to giving up pay. After that, you might prefer to make additional contributions to a personal pension or self-invested personal pension (Sipp), unless your employer offers an additional voluntary contribution scheme with low charges and a good choice of funds.
There are only two groups who might not want to contribute to pensions: the very poor and the very rich. Mr Modray warns that the effect of pension tax credits could wipe out any benefit from a very small pension so that "you might find yourself no better off than if you hadn't bothered saving".
Conversely, wealthy savers could be affected by the lifetime limit on pension funds: £1.6m for the 2007-08 tax year, above which excess pension funds will be taxed at 55 per cent. It is possible to apply to protect your pension pot, indexing it against the lifetime limit, if you apply before April 2009, but you can only do this if you are already above the lifetime limit.
Some wealthy individuals may therefore have to stop making pension contributions, as they will be close to the lifetime limit and crossing it would be senseless due to the penalty tax.
If you find yourself in that position, you might be able to ask your employer for extra pay, instead of pension contributions. You could also use additional tax-free wrappers, including Isas and venture capital trusts (VCTs). VCTs allow up to £200,000 a year to be invested in portfolios of small companies, with no tax on gains or income and 30 per cent initial tax relief, in return for a five-year holding period.
Some professions, such as sports, allow retirement as early as 35, but are hit by a reduced lifetime limit (falling by 2.5 per cent a year). So retiring sportsmen might also need to use additional tax wrappers to boost their retirement funds. From April 2010, however, such early retirement will be impossible, with 55 becoming the earliest retirement age for everyone.
Flexibility
Pension saving therefore requires discipline because your pot cannot be unlocked until you reach 55 (from 2010). After that, you could take the 25 per cent tax-free cash, but keep on investing in the pension and take benefits later, or take your full pension in a variety of ways, from buying an annuity to drawing down income.
By contrast, Isas can be tapped into at any time, making them useful for medium-term savings, as well as acting as rainy-day funds (advisers suggest you should keep around three months' salary in cash to cope with emergencies). Brian Dennehy, of IFA Dennehy Weller, points out: "During a long retirement, you will need flexibility, which is where Isas come in, as they allow ready access to your capital."
Some people will prefer to focus on dealing with debts, family expenses and mortgages before saving for retirement, but delaying pension saving will mean you miss out on the important effect of compound returns over the long term. And how long you invest for will affect your choice of assets to hold.
If you are using your Isa as an accessible short-term vehicle and see your pension as a long-term investment, you could put your Isa into low-risk assets, such as cash or bonds, and hold riskier assets in your pension, hoping their volatility will pay off in the long-term.
On the other hand, you might prefer to have a flutter in your Isa and take a lower- risk approach with your pension. Mr McDermott explains: "I take much less risk on my pension than I do on my Isa. In last year's market correction, my Isa lost 16 per cent in two months, whereas my pension lost only 2 per cent."
If both pension and Isas are for retirement, though, you would do well to view your asset allocation over both wrappers as a whole, in order to ensure sensible diversification and avoid being dangerously overweight in any one area. This is increasingly simple, thanks to the advent of fund supermarkets and wrap accounts.
Although pension funds have a reputation for mediocre performance, it is now possible to invest in top-class funds through most personal pensions and in a wide range of investments inside Sipps. Indeed, Sipps allow greater freedom than Isas, with derivatives, individual hedge funds, direct commercial property, residential property funds and unquoted shares all allowed in Sipps but not in Isas.
Retirement income
It is normally a good idea to take the tax-free cash from a pension, provided you use it sensibly. The one exception is with final-salary schemes, where you would be reducing a guaranteed income and taking on investment risk.
If you do take tax-free cash, you can then invest it in Isas and tax-free products from National Savings & Investments for a tax-free income. You can also hold growth-investments outside an Isa and strip out gains as income, using your capital gains tax exempt allowance. Income from a purchased-life annuity will also avoid some tax because part of the yield is treated as return of capital (whereas income from standard compulsory purchase annuities is taxed in full).
Another route is to use investment bonds, where income of 5 per cent a year can be taken tax-free. With offshore bonds, you can roll up gains and pay income tax when you encash the bond, perhaps engineering being a basic-rate taxpayer or living in a tax haven. Offshore bonds can also be written into trust to your descendants, meaning they would be potentially-exempt transfers (PETs), escaping inheritance tax after a seven-year period.
Inheritance
Isa funds can be passed on simply (minus the tax wrappers) as PETs to reduce the size of your estate. It is harder to pass on a pension, but there are still some options.
Although the government has cracked down on inheritance-tax planning through pensions by slapping a 70 per cent charge on alternatively secured pensions (ASPs), as well as inheritance tax, Mr McPhail comments: "There is still room for bequest planning using pensions." He notes that you can buy single-life annuities with 10-year guarantees at the age of 75, meaning your pension would be paid to your spouse, dependent or estate, if you died before 85.
Alternatively, you could take an unsecured pension (commonly known as income drawdown) before the age of 75 and strip out as much income as possible. You can take up to 120 per cent of the comparable annuity rate (set by the Government Actuary's Department) and could then gift that away as PETs.
You could even use your retirement income to pay for stakeholder pension contributions for children and grandchildren, recouping more tax relief. Regular contributions out of pension income are exempt from inheritance tax, provided they do not affect your standard of living.
An annuity is lost to your estate on death so many people put off buying one for as long as possible. A new breed of flexible annuities, from providers such as Aegon, Hartford Life and Living Time, offer steady incomes with guaranteed lump sums up to the age of 75. This allows you to defer buying an annuity for as long as possible, without the investment risk of drawdown. The deadline is age 75, after which the only alternative is the ASP, which has been loaded with death taxes of up to 82 per cent.
If you die before taking pension benefits, your fund is passed on tax-free as a lump sum or a dependent's pension. If you die while in drawdown mode, your fund can be passed on as a lump sum after a 35 per cent tax charge or tax-free as a spouse or dependent's pension.
