I earn £50,000 a year and want to save for my retirement. I have around £10,000 to invest. I have a mortgage but no other debts. What should I do?
There is a general misconception that retirement planning means paying money into a pension. A pension is simply a tax-advantaged investment. For tax efficiency and flexibility, it is often best to hold a mixture of pensions, investments such as Isas, cash and other assets at retirement. Paying down a mortgage is an equally good way of saving for retirement.
The first place to start should be to double-check how your employer-sponsored pension works, if you have one. In my experience, most people do not fully understand what is on offer via their employer’s scheme.
On top of the standard level of contributions, many employers will match any payments you make up to, say, 5 or 10 per cent of salary. That is a fantastic benefit (free money basically) and worth taking advantage of.
If you did have this matching facility on, say, 5 per cent of salary, it would only cost you £1,500 after higher-rate tax relief to have £5,000 invested in your name. That would be a pretty good return on your money.
If you have a final-salary scheme, you may have the option to buy added years which can also be extremely valuable, particularly if your salary is likely to rise.
Remember that pension contributions attract tax relief at your marginal rate of tax but are then taxed when benefits are taken at retirement. A 25 per cent tax-free cash lump sum is available from most pensions at retirement.
For higher-rate taxpayers, a £60 net contribution will be grossed up to £100 with the benefit of 40 per cent tax relief. Where personal pensions are concerned, 22 per cent of this is provided at source and the remainder must be reclaimed through your tax return. The fund itself will grow in a tax-advantaged manner.
The most efficient way of saving into a pension is to receive higher-rate tax relief on your pension contributions but to only pay basic-rate tax on your retirement income. For nil, 10 and 22 per cent taxpayers, there is generally not such a big advantage in paying into a pension as you receive basic-rate tax relief at source but then usually pay basic-rate tax at retirement.
One of the main disadvantages of a pension is that benefits cannot be taken until age 50, rising to 55 in 2010, and there is no guarantee that it will not rise further at a later date. Also, at some point you may be forced to buy an annuity which might not suit your circumstances at the time.
Isas are much more flexible, so if you did need to call on this money in an emergency, you could. You do not pay any tax when you take the money out of an Isa but you do not receive tax relief on the money invested.
The Bank of England base rates is currently 5.75 per cent so let us assume you are paying 6.25 per cent interest on your mortgage. You would need to make a risk-free return of 6.25 per cent a year on your Isa to beat paying down the mortgage. You would expect to make more than this in an equity portfolio over the longer term but would be taking a considerable amount of risk to achieve this. It depends on your attitude to risk. Paying down a mortgage is just as valid a way of saving for retirement as a pension or Isa but many people forget to think of it as a savings vehicle.
The higher-rate tax threshold stands at £39,825 which means you could make a £10,000 gross pension contribution and receive 40 per cent tax relief on the whole amount. The net cost to you would be £6,000 which would leave £4,000 to pay down the mortgage or invest in an Isa.
In conclusion, it depends on your priorities, attitude to risk, employer pension, mortgage interest rate and what access you need to your money. For a higher-rate taxpayer, pension contributions are likely to be the most efficient method, particularly if your employer offers matched contributions.
It is best not to have all your eggs in one basket and the optimal approach is likely to be a mixture of a number of measures.
Jason Witcombe is director of Evolve Financial Planning