Under the previous Government, using ISAs in retirement planning began to make real sense but, now the rules have been revised once again, does that still hold true?
The choice of using ISAs to supplement, or replace traditional pension saving became an increasingly significant debate under the last Labour Government as they removed some of the tax relief’s on pensions for higher earners. This system saw higher earners potentially only receiving 20% tax relief on contributions, where they may still have to pay 40% or 50% tax on the income ultimately received.
The new pension rules have now been revised and the argument for using ISAs, whilst not invalidated, is not as clear cut as it may have been previously.
The tie between ISAs and pensions is commonly made and with good reason, they share the same fundamental rules for the underlying investments. Income and capital gains can roll up free from income or capital gains tax. In addition, the range of investments in equities, bonds, properties are typically very similar and wide-ranging. These investments are often flexible with easy, low-cost switching options. This is however, where the similarities end.
Pensions have significant advantage at the point of investment. They attract marginal rates of income tax relief. On the other hand, ISAs must be bought with net, taxed income. Contribution limits on pensions are also more generous for many of us – even with the annual allowance being cut from £1.5m to £50,000. ISA susbscriptions are currently limited to £10,680pa.
When consuming the wealth that has been accumulated, the coin flips, and ISAs become more attractive. Investors in ISAs can take their income whenever they like and it is paid tax-free – whether it takes the form of capital redemption, interest, dividend or rental income.
Pensions are limited in when you can draw them – the minimum age is now 55 and this may have risen higher by the time our younger readers reach retirement. On top of this, only 25% of the fund can be taken as a tax free lump sum with the residual used to purchase an income – which is taxed at the marginal rate.
On the charging front, ISAs have historically been less expensive than pensions and the compound impact of this can be significant.
With the benefit of your saving seemingly a choice between upfront or tail end benefit, it can be difficult to consider which is the most efficient way of saving for your and entering into retirement. Indeed this choice needs careful consideration and planning based on your own personal circumstances.
That said the argument for pensions is currently the most compelling. The compounding effect of tax relief can be hugely significant particularly over a 20-30+ year term to retirement.
For higher and additional rate taxpayers that will or may remain so in retirement, supporting your pension savings with ISAs can provide additional tax-free income and the combination of the two vehicles can be used to good effect with effective planning.
As a final point, where an employer sponsors retirement savings it is almost certainly worth first contributing to draw the maximum benefit from your employer.
In summary, there are advantages and disadvantages of using ISAs and/or pensions for your retirement savings. The key message of course, is that saving for your retirement is now more important than ever. A continuously ageing population will add additional strain to the State Pension system and relying on this is a bold move indeed.
Pensions will, for many, be the most appropriate selection but ISAs certainly have their part to play in a retirement strategy – the best course of action is to discuss with a professional adviser and develop the most appropriate strategy for you.
