Pensions versus Isas: a beginner's guide
The government is happy to incentivise people to invest, but is not keen to give them all their tax-break goodies in a single product. As such, it allocates a few to an Isa and a few to a pension.
This leaves investors with the thorny job of deciding which is the best option for their savings.
In an ideal world, the answer is probably 'both', but not everyone has £60,000-plus to invest each year, so most will have to make a choice.
Adrian Boulding, director of policy at NOW: Pensions, is clear that there is no universal solution: 'The right option will be different for different people. There will be some for whom the right answer is a pension, others for whom the right answer is an Isa. If it was clearly one or the other, it would be far simpler.'
With pensions, the incentives are all upfront. The government gives tax relief on all contributions to a personal or work-based pension, topping up the final payment to reflect tax paid.
This is best for those who have paid a lot of tax - 40 or 45 per cent taxpayers - because they get higher tax relief. It also means that more goes into the pot early, allowing investors to benefit from compounding for longer (providing their underlying investment goes up).
But pensions come with some notable drawbacks. In particular, they are subject to constant tinkering by cash-strapped governments who see pension tax relief tweaking as an easy way to balance their books. Moreover, investors can't get hold of the cash until they are 55 (moving to 57 by 2028).
Additionally, there are ever-changing rules around contribution limits. At the moment the annual contribution limit is £40,000, but it reduces for higher earners, and for those already in drawdown, and so on.
A nice straightforward Isa gets round many of these issues. Contributions are made out of taxed income, but Isas are supremely flexible and money can be accessed at any time.
Andy Parsons, head of investment research and advisory services at the Share Centre, says the government has moved to make these even more flexible in recent years.
'It is now possible, if you need short-term access, to take cash out and retain your Isa benefits, as long as you put the money back in by the end of the tax year,' he says.
However, he adds that this isn't always an advantage. It is fine for the financially self-disciplined, but it's a little like having a jar of coins in the kitchen - it is tempting to keep taking money out to fulfil short-term needs.
With Isas, all the benefits are on the way out. Any income paid out is tax-free. While this means that investors can build a tax-free income to draw upon in retirement, it also means that there is less benefit from compounding over time because tax has already been deducted.
Investors should also bear in mind that they get a 25 per cent cash-free lump sum with their pension; in addition, under 2015's pension freedoms they can take their pension benefits in chunks and therefore manage their tax liability to some extent.
To complicate matters, in April the government is launching its new Lifetime Isa, which looks like a hybrid of pension and Isa. This has many of the Isa advantages - tax-free income and gains - but also gets a chunky upfront top-up from the government of £1 for every £4 you contribute.
While this appears to be a perfect solution, it does come with some significant restrictions. First, the upfront top-up is available only if the money is withdrawn for one of three specific reasons: buying a first home; retirement at age 60 or over; or diagnosis of a terminal illness.
Money can be withdrawn for other reasons, but the government will take back 25 per cent of the total fund - its original 20 per cent top-up plus any capital growth, and a 5 per cent penalty.
Boulding believes this 'clawback' may be a real problem for Lifetime Isa investors: 'You need to know what you're saving for. People may not understand that they will suffer a real financial penalty if they choose to use the money for a holiday or a car.'
Another problem is that the Lifetime Isa is only available to those aged 40 and under. With that in mind, an investor should take the following into consideration when selecting a tax wrapper:
HOW WILL THE MONEY BE SPENT?
When deciding on the best option, Richard Parkin, head of pensions policy at Fidelity International, says investors need to look for the obvious answers first.
'It helps if investors focus on what they are trying to achieve - if they are trying to buy a first house, for example, it makes sense to look at the Lifetime Isa.'
The trouble is that they have to be certain that the money is for a first home, or be willing to leave it for decades as a retirement pot. If the money is for retirement, a pension usually wins out.
Rob Morgan, pensions and investments analyst at Charles Stanley Direct, says: 'In the majority of cases, the benefit of upfront tax relief at a person's highest income tax rate means investing in a pension works out better. This reflects the fact that pension tax relief on the way in makes an important contribution to overall return.
'The fact that you can generally take 25 per cent as a tax-free lump sum before drawing the pension also helps... Of course no one knows their future tax position - and tax rules can change.
'However, as it stands, a pension often remains a mathematically more appealing retirement investment vehicle.'
He also points out that Isas don't give the option of a conventional retirement annuity.
WHEN DO YOU NEED THE MONEY?
Boulding suggests thinking in terms of three pots: One is 'rainy day' money for emergencies. This probably needs to be held in cash.
The second is 'sunny day' money, saving for a holiday or a house deposit, which probably requires the flexibility of an Isa.
The third is 'twilight savings', where investors are probably still best off investing in a pension.
WHAT IS YOUR EMPLOYMENT STATUS?
There is one consideration that trumps all other options, and that is whether an employer contributes to a pension.
Parkin says: 'One thing we are trying to get across is that if your employer is contributing to your pension scheme, there is almost no question of using anything other than a pension.'
Boulding agrees, pointing out that most employers are now compelled under auto-enrolment to provide a contributory pension. They will usually match the employee's contribution, and that contribution is not considered a benefit in kind.
Under the rules, employers must pay 3 per cent into their employees' pensions, as long as employees are contributing 4 per cent; the government then tops up the contribution with a further 1 per cent in tax relief - a win/win arrangement for the employee.
For the self-employed (and under 40s), the Lifetime Isa may be a more attractive option. The tax relief is slightly higher, investors aren't missing out on employer contributions, and the income is tax-free at the end.
WHAT'S YOUR TAX POSITION?
Investors may also be influenced by their tax position now and in retirement. For those receiving higher-rate tax relief and then paying only basic-rate tax in retirement, there is a clear advantage to pensions.
Even for those likely to have the same tax rate in retirement as when employed, pensions usually win.
Morgan says the main exception is for a basic-rate taxpayer funding a pension and then becoming a higher-rate taxpayer when taking benefits. In this case, he says, an Isa produces a better overall return.
Investment flexibility may be a concern for some people. In practice, however, the products do not differ significantly. Lifetime Isas are shaping up as platform products, so are likely to have the same flexibility as normal Isas.
Employer pensions may have a more limited range of investment options, but this is more than outweighed by the additional contributions.
The inheritance tax treatment of Isas and pensions may also have some bearing on people's choice.
As it stands, Isas form part of an estate for inheritance tax purposes, whereas pensions don't. Isas can pass to a spouse tax-free, but there will be tax penalties if they are left to anyone else.
For those who are saving a few hundred pounds a month 'for the future', it makes sense to split it between pension and Isa, balancing flexibility and tax incentives. Those with more specific needs need to look more carefully.
- Buying a house (as long as you're sure)
- Self-employed pensions
- School fees (income is tax-free)
- Non-targeted savings (holidays, cars)
- Extra income in retirement
- Those with an employer contribution
- Saving for retirement
- Those who want to leave money to children