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Comparing the tax efficient options
With life expectancy increasing, financial planning is becoming increasingly important. If you are thinking of saving for retirement, then you might consider a pension is the best way to ensure you have enough to live on when you are older. However, this is not the only way to achieve your retirement goals. In particular Individual Savings Accounts (Isa) can be a useful tool.
Pensions and Isas are taxed differently. Your pension payments will qualify for tax rebates upfront at your highest rate of income tax, but then the income you receive, once you have taken out your tax-free lump sum, will be taxable. With an Isa, contributions are made out of taxed income but any withdrawals are tax-free. Also, be aware your pension income counts towards your personal tax-free allowance while your Isa withdrawals do not.
As such, the choice of pensions or Isas can seem a straightforward question of rates. If someone receives higher rate tax relief on their pension contributions, but is then only paying lower rate tax on their income at retirement, pensions make better sense. For those whose income may be greater in retirement, the opposite is true.
However, it is not so clear-cut. The tax rebates are important as they add value upfront and investors enjoy the effect of compounding on their portfolios. This will influence the size of annuity that can be bought. Equally, if you use it to buy a pension annuity, those payments are guaranteed for life, while withdrawing the equivalent from an Isa can be less predictable. Other pension benefits include that employers can pay into a company or stakeholder pension scheme, and the annual contribution limits for pensions are much higher than for Isas.
Nevertheless, an ISA is much more flexible. Annuities in particular can be inflexible and once bought, leave little or nothing in the pot. Also, with a pension, you have to wait until you are 55 to make withdrawals, whereas an ISA can be accessed at any time, although this may not always be a good thing.
With longer life expectancies, as well as some high-profile issues concerning how a minority of pension funds have been managed, many investors’ retirement sums will not provide quite as much income as expected. As a result, some people are now looking to boost their pension funds by topping up their company pension or by using additional investment vehicles. The question is often not whether an Isa or pension is better but how to structure a portfolio using both.
Paul Dixon FPFS
Chartered Financial Planner