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Personal pensions versus Isas

As we approach the end of the tax year, many people will be bombarded with Isa literature, highlighting the need to use up their Isa allowance by April 5 or lose it for good.

But anyone wanting to maximise tax breaks should also ensure that they remember their pension planning. This April 5 brings the end of carry forward, creating a major buy now while stocks last opportunity for those with personal pensions.

In future years, the introduction of the new pension tax regime introduces a use it or lose it April 5 deadline for both personal and stakeholder pensions.

But what are the key differences between Isas and personal pensions (including, in future, stakeholder pensions) and if tax efficiency is the key aim, should individuals not use up their full pension contribution allowance before topping up their Isa?

The tax breaks granted to Peps and now Isas have undoubtedly reduced the relative tax efficiency of saving for retirement through “true” pension policies.

While many people would be well advised to have a modest element of liquid savings in an Isa, does it make tax sense to go beyond this and treat the Isa as a core part of saving for retirement?

As well as considering differences in tax treatment, it is necessary to consider differences in charging structures.

On both these counts, there are strong indications that personal pensions are still the best method of saving to provide an income in retirement.

Taxation

Table 1 highlights the key differences in tax treat-ment of personal pensions against Isas.

As can be seen, both products have un

ique tax features, which are not immediately comparable.

Table 2 on the page opposite illustrates the projected post-retirement income from a personal pension and an Isa for a 35-year-old male contributing £1,000 a year of post-tax salary for 30 years.

These assume that both products have a single fund-related charge of 1 per cent and achieve a return of 7 per cent a year before charges. It is assumed further that the individual is a basic-rate taxpayer in retirement.

The table assumes that the fund less personal pension tax-free cash is used to generate income.

For the personal pension, this is assumed to be through the purchase of an annuity, assuming an underlying interest rate of 5 per cent.

Under the Isa, the most tax-efficient method is to take regular withdrawals from the fund. The figures shown assume the Isa pot grows post-retirement at 5 per cent and is exhausted over the individual&#39s life expectancy.

This introduces the risk of running out of money is he lives longer than expected, but would produce a residual pot should he die earlier than expected.

To allow for the 10 per cent tax credit within the Isa until 2004, it has been assumed that half the expected return arises from dividends.

Table 2 shows that the post-tax income on retirement is higher for a personal pension than an Isa, particularly for those who are higher-rate taxpayers while contributing but subject to only basic-rate tax in retirement.

For the basic rate taxpayer, the main difference is down to the fact that tax is only payable on 75 per cent of the fund (due to the 25 per cent tax-free lump sum) whereas all Isa contributions have borne tax.

The effect of this is much higher than the effect of the temporary 10 per cent dividend tax credit.

Even if the tax credit within Isas were to continue indefinitely, the personal pension would still produce a higher income even for basic-rate taxpayers.

Inheritance tax

A further issue to consider is the inheritance tax position. Subject to a suitable trust wording, any death benefit from the personal pension can be outside inheritance tax.

However, Isas cannot be written under trust so if, on death, the proceeds are passed to an individual other than the spouse, the recipient could be subject to an inheritance tax charge.

Charges

So far, it has been assumed that the total charge for both the personal pension and the Isa is 1 per cent of fund a year.

Table 3 details average charges for Isas and personal pensions. These are taken from the 1999 Disclosure Report from the PIA. They assume 7 per cent growth and a regular contribution of £60 a month. Reduction-in-yield figures are shown after 25 years.

The figures shown in Table 3 relate back to 1999 before the impact of stakeholder had driven down personal pension charges even further. While the 1999 results did vary considerably between providers, they show clearly that the average PP has lower charges than the average Isa.

Clearly, there is a place for holding an element of savings in liquid form and an Isa investment allows this in a tax-efficient manner. But when longer-term retirement saving is the aim, personal pensions can offer not only lower charges but also considerably higher tax incentives.

This is particularly, but not solely, true for higher-rate taxpayers.

This, along with the new yearly cut-off dates for pension contributions, should act as a powerful selling tool for pen- sion specialist IFAs. 

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