Pension or Isa? What is your recommendation for retirement savings?
In the last 10 years, pensions have received a lot of very negative press. There has been the Chancellor’s tax grab on dividend income, the ongoing backlash from pension misselling, concerns over having to purchase an annuity at retirement and, of course, significant falls in markets from 2000 to 2003.
Some of these concerns have been alleviated. There has been a significant bounce back in markets, although equity investments will always have a degree of volatility. And the legislation which came into force in April 2006 means it is no longer compulsory to purchase an annuity, even after age 75.
Pensions will always be attractive due to the tax reliefs on offer – funds grow free from tax (apart from the effective 10 per cent tax on dividends) and 25 per cent of the fund is available as tax-free cash on retirement.
Isas also have tax advantages and some advisers and market commentators feel they are a suitable alternative to providing income in retirement. Isas also grow free from tax although, like pension funds, they too suffer from the inability to reclaim the tax credit on dividends. Unlike pensions, the money is always available, although this could be a disadvantage if it is spent before reaching retirement. But if the pot remains untouched, the big attraction of Isas is that the funds and their growth/income can be taken as tax-free income in retirement.
Savers should be aware that the limits on how much can be paid into Isas (£7,000 for the current tax year, increasing to £7,200 a year thereafter) make it difficult to use them for fully providing pension income. Up to 100 per cent of salary can be paid personally into a pension (which can be topped up by £225,000 from your employer), subject to not exceeding the lifetime allowance.
Which is best – tax relief plus restrictions or no tax-free cash and the ability to take tax-free income in retirement?
In many respects, if you can afford to, you should look to have both. For many, a pension will attract higher-rate tax relief at 40 per cent and a quarter of the fund is available free from tax – and for most, the pension will only be taxed at 22 per cent when taken.
For many, Isas are attractive due to the accessibility of the capital with the ability to access the cash in emergencies, for example redundancy or sickness. If debts have accrued, it is better to pay them off, which would not be possible from a pension fund. And just when you think children become cheaper, they hit 18 and could need support in higher education and later, help in buying their first house, or getting married, all of which is easier to fund via an Isa.
How much income you need in retirement depends largely on how long you have before you retire and your income expectations. After 40 years in a good final-salary pension scheme, you would expect to receive a pension of two-thirds your final earnings but, assuming the mortgage has been repaid by retirement, many feel they can afford to live on 50 per cent or less.
The following example shows how pension and Isa savings can work together to provide retirement income. Assuming a pension fund of £400,000 had been accumulated, £100,000 in Isas and a state pension of, say, £7,500, including Serps, the income and taxation position could be as follows:
Assuming you receive an income of 6 per cent a year from your Isa and 25per cent tax-free cash is taken, again providing income of 6 per cent, your total income would be £37,500. Tax would be payable on £25,500, around £4,000, netting your income to £33,500 a year.
Could you afford to live on this level of income? If not, you need to save more. Will you have this level of capital available by retirement? If you need this level of income, you will have to save more – or retire later. It should be noted that the further you are from retirement, the more you need to make allowances for inflation.
In many instances you will also have a pension provided by your employer and so should always take advantage of any contributions they are willing to make on your behalf.
Lisanne Mealing is a director at MDM Associates.