Inflation and low interest rates have combined to punish the returns on cash Isas. Alastair Wilson of Zurich UK asks whether moving cash into a pension could help boost flagging returns.
There has seldom been a worse time to hold cash in an Isa. With interest rates stuck in the doldrums, savers are seeing their nest eggs eaten away as inflation creeps ever higher.
The consumer prices index measure of inflation hit 2.9 per cent last month, rising to a four-year high, with some predicting it will go on to top 3 per cent.
So how you can you protect your nest egg as prices continue to rise?
Moving your pot into a stocks and shares Isa or investing it in funds might be an obvious solution.
But there is another way to grow your cash and benefit from stock market returns – switch your Isa into a pension.
Pensions are now far more flexible. Like Isas, they offer tax free investment growth. But they also come with a ‘cash bonus’ from the Government and can prove significantly more tax efficient to pass on.
So, if you are nearing or are already in retirement, here are three reasons why a pension could be a better home for your cash savings.
Using tax relief to boost returns
One of the most attractive features of a pension is tax relief – ‘free money’ from the Government that gives your pot an instant boost.
Any money you pay into a pension gets a 20 per cent top up from the taxman, and if you are a higher or additional rate taxpayer, you get a further 20 per cent or 25 per cent off your tax bill when you file a return.
For a higher rate taxpayer, a £20,000 Isa pot would be worth £25,000 in a pension. The individual would also get a further £5,000 income tax refund, as a larger slice of their income will be taxed at 20 per cent instead of 40 per cent.
Also, as many people’s total income is less in retirement, they could move from being a higher rate taxpayer to a basic rate taxpayer, meaning the gain would be even greater.
Pensions can be better for passing on wealth
Pensions have another advantage over cash Isas – they are more flexible and tax efficient for passing on wealth to loved ones.
If you die before age 75, your family won’t pay any tax on your pension.
You can choose who will inherit your pension savings – a partner, children or even grandchildren – and they will be able to draw an income with no tax to pay.
If you die after age 75, pensions are taxed as income, or can be taken as a lump sum, at the beneficiary’s marginal tax rate.
Keeping your money inside a pension also means it is free from inheritance tax (IHT). In comparison, any money in an Isa is treated as part of an individual’s estate for IHT purposes.
If the fund exceeds the IHT threshold of £325,000, beneficiaries could be landed with a 40 per cent tax charge.
It is possible to pass on the tax advantages of an Isa, so that beneficiaries receive an increase in their Isa allowance equal to the value of the person’s pot at the time they passed away. But this is only available to a surviving spoue or civil partner, unlike a pension which can be passed on to anyone.
Better Flexibility Means Pensions Cash no Longer locked up
Any money you pay in to a pension is typically locked away until age 55. However, when you come to take your cash out in retirement, pensions can now offer just as much flexibility as an Isa.
In the past, retirees were typically required to buy an annuity with their pension pot. Now, you can take out lump sums from your pot, or draw a regular income from it.
But beware of the Drawbacks
It’s important to remember that you can only pay a sum in to your pension that is the higher of £3,600 or 100 per cent of your earnings. Any more, and you could be hit with a hefty tax charge.
Likewise, there is also an annual £40,000 limit, beyond which any contributions are taxed at your marginal rate. However, you can potentially carry forward any unused allowances going back three years.
If you are looking for a way to make your cash savings work harder, and can afford to lock money away for the long-term, then a pension can be a flexible and tax efficient wrapper.
As ever, seeking qualified financial advice is the best way to decide if this option is right for you.
Alistair Wilson is head of retail platform strategy at Zurich UK
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