Pensions are the obvious tax shelter for retirement savings, particularly self-invested personal pensions (Sipps) which offer you investment flexibility. But as to which tax wrapper should win in a fight between Isas vs Sipps, there are many factors in your decision - and this should be personal, rather than proscribed. Here, instead, are a few key things to think about if you have a spare £10,000 and are wondering which wrapper to choose.
Sipps are much more tax-efficient than Isas, but Isas are more flexible.
The key benefit of a pension is the tax relief on the contribution at entry. A pension contribution of £10,000 made by a basic rate taxpayer only costs £8,000 after income tax relief. For a higher rate taxpayer, the net cost is £6,000. This has the effect of a guaranteed instant growth of over 25 per cent for the basic rate taxpayer and 66 per cent for the higher rate taxpayer - the equivalent of more than 20 years in the building society at current rates, but overnight.
To put these instant pension uplifts to your money into context: should you invest your £10,000 into a stocks and shares Isa and it performs well, growing at 6 per cent a year after charges, it would take more than four years to get a 25 per cent uplift and 11 years to get the 66 per cent uplift. In the meantime, your pension would have been galloping away, with the compounding effect of interest on the tax relief making it far the superior performer.
But you could equally say "stuff the tax relief on pensions". The fact that you lose control of your money is the best argument against pension plans. The lack of access to your money until you are 55 in a pension is often a moot point with many people. Even then the Sipp investor can only take 25 per cent of the pension fund value directly free of tax, while the rest must be taken as a monthly taxable income. Even though pensions can work very well if you are a higher rate taxpayer while contributing and a basic rate taxpayer in retirement, many investors find the lack of access demotivating.
Second, restrictions on drawing an income in retirement from pensions have made an intolerable situation for retired pension holders. You either have to buy an annuity - and rates are the lowest they have been in years or you draw income directly via drawdown. However, the GAD rate by which income drawdown limits are set has dropped to unbearably low levels, meaning many pension investors can't get enough of their money out.
You may be comfortable with the draconian rules surrounding pensions. If you are not, choose an Isa first. Isa investors have access to their money at all times and can draw a tax-free income at anytime. A key advantage of Isas is the income that you take from one doesn't need to be entered on a tax return, so it doesn't count towards the limit for the increased age-related personal income tax allowance available to those aged 65 and over.
A good strategy is when you are younger and trying to build up money you put spare cash into an Isa. Then when the time is right, ie you become a higher rate taxpayer or can afford to lock your money away until age 55, you can encash the Isa and put the money into a Sipp, taking advantage of the 40 per cent relief. If your earnings are likely to stay within the basic rate tax band, the trigger for moving cash from an Isa into a Sipp might simply be when you feel comfortable in committing money for a longer period of time.
Finally, governments love to tinker with pensions - one of the major downsides. In 2009-10, the year for which the most recent figures are available, the government granted £28.15bn in pension tax relief.
There are suggestions that higher rate relief could be reduced or removed from pensions. There have also been rumours that the 25 per cent tax free lump sum may be reduced. The problem with locking your money away for such a long period is that pensions legislation can change (and has done frequently and recently). So what seems advantageous now, may not be in future.
In contrast, the estimated exchequer cost of the tax relief for Isas in 2010-11 was £2.1bn - so not much to be gained from tinkering with the system. That's not to say that Isas may not change too, but if they do become less advantageous you can get your money out. That is not the case with pensions.
*Please note that this is not an exhaustive list of all the factors to consider when weighing up Isas vs Sipps. I have simply highlighted the most pertinent ones.
