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Alternatives to pensions

Managing one’s investments (incorporating appropriate asset allocation) to produce acceptable returns while managing risk takes absolute priority in portfolio planning. However, maximising the tax efficiency to minimise tax on investments can substantially add to the bottom line.

This year’s Budget proposed some radical taxation changes that will undoubtedly have an impact on the choice of the most appropriate tax wrapper or wrappers for an individual’s investment portfolio.

Prime contenders include the raising of the Isa allowance to £10,200, the scrapping of higher-rate tax relief on pension contributions made by high-earners, the introduction of a 50 per cent top rate of tax for top-earners and the introduction of an effective 60 per cent rate for income falling between £100,000- £114,000 (ish). And let’s not forget the important changes to the taxation of UK and offshore funds.

I will look at all of these changes in a little more detail over the course of the next few weeks.

Most will conclude, without the need for a detailed analysis, that the post-2011 tax saving appeal of a registered pension for a taxpayer with income over £150,000 will undoubtedly be reduced. At the most superficial level, the constraints of a registered pension (for example, 75 per cent of the fund used to provide an income that could be taxed at 40 per cent or 50 per cent and no access to cash) may be thought to be an unreasonable price to pay in return for tax relief at 20 per cent.

But let’s also not forget that the removal of higher-rate tax relief on pension contributions will only apply to a very small number among the population and so the thinking that has underpinned retirement planning for individuals so far will continue to be valid.

And even for these, some will have chosen other than pension vehicles as the only or part of the basis for providing for retirement. The proposed removal of higher-rate tax relief will, for those affected, accelerate this dynamic.

What are the pension alternatives that could be considered?

Let’s look at Isas first. These are the most obvious pension alternative, offering tax freedom on the underlying fund. OK, no tax relief on the way in but tax-free benefits on the way out.

The value of tax freedom on emerging benefits in a world where tax rates look to be on a one-way (high) street to pay for our burgeoning public sector borrowing looks to be highly desirable, assuming that you can trust future Governments not to remove tax freedom from existing Isas.

Despite the undoubted current tax attraction of pension contributions, though, if there is a risk of the investor being over the threshold above which higher-rate relief is not given, the “invest in an Isa and dump into pensions later” strategy might be a little risky.

For potential high-fliers looking to put in place a “deferred pension” strategy, it may make sense to review these plans in the light of the possible constraints on securing higher-rate tax relief in the future when they may be caught by the restriction.

Subject to all of this, the Isa is still the main non-pension method of investing savings with freedom from income tax and capital gains tax on the fund and on extracted benefits.

From April 6, 2009, the annual contribution limit is maintained at £7,200 with the maximum contribution to a cash Isa being £3,600.

From October 6, 2009, the maximum contribution for those aged 50 and over is raised to £10,200, with the maximum contribution in cash being £5,100.

This means, rather oddly, that while the total contribution limit for the whole of this tax year is £10,200 for the over 50s, only a maximum of £7,200 can be invested before October 6.

From April 6, 2010, the new increased limits will apply to all qualifying Isa investors.

This substantial increase in the investment limit (for older investors first), while valuable to all, will be particularly welcome for those who will be adversely affected by the removal of higher-rate tax relief on pension contributions and those who will pay the higher 50 per cent rate of tax on income.

It may also be welcome for 40 per cent taxpayers who are not enamoured with what they may perceive as the constraints of a registered pension.

The value of the tax freedom on income delivered by the Isa will effectively increase for prospective 50 per cent taxpayers and those who could be caught in the 60 per cent trap in which personal allowances are removed.

Of course, apart from not qualifying for tax relief on the Isa investment, the Isa is also non-assignable and so will remain in the taxable estate of the investor for inher- itance tax purposes.

More on pension alternatives next week.


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