RECENT changes to pensions and savings have given savers an unprecedented opportunity to exploit the distinct tax advantages individual savings accounts (Isas) have over pensions.
When the annual limit for Isas rises from £7,200 to £10,200 on 6 October for those over 50 (and from next April for everyone else), it will make even less sense for a basic rate taxpayer to contribute to a pension while they have an Isa allowance to
use up.
Many investors have realised that Isas are an ideal vehicle for long-term retirement savings. However, few organisations are prepared to champion the alternative to pensions, as few providers have the infrastructure to offer an Isa product integrated with a pension contract.
What's more, large up-front commission fees are generated from pension payments on the basis that the money is locked up until retirement. As Isas do not suffer from that inflexibility, they do not facilitate large up-front commission structures. Could industry self-interest be getting in the way of best savings practice?
For example, take two sets of investors, starting off as basic rate taxpayers and ending up as 40 per cent taxpayers, both putting in £1,000. One invests the money in a pension and the other in an Isa.
The pension investor gets tax relief at 20 per cent, taking his investment to £1,250, which doubles over the next ten years, giving him a £2,500 pension.
The Isa investor, meanwhile, gets no tax relief, so after ten years his money also doubles to £2,000. If that money is invested into a pension with 40 per cent relief on it, this would take the £2,000 up to £3,333. This difference becomes even more marked at the marginal tax rates of 61 and 50 per cent.
Introduced by the government in 1997 as an incentive for people to save, the Isa allowed small investors to wrap up stocks, cash and insurance in one account. The system was simplified in April 2008, with the scrapping of "maxi" and "mini" Isas and the maximum investment in any one tax year was raised to £7,200 from £5,000. The rules changed last year to allow switches from cash to stocks and shares.
There are around 18 million Isa account holders in the UK, with five million using the full allowance each year.
For people looking to safeguard their future by saving, the best advice would be to use the Isa allowance fully (and arguably exploit their capital gains tax allowance where possible). This provides them with access to their capital – a huge impediment to pension saving – while giving greater flexibility in later life.
For higher-rate taxpayers, the best idea is to consider pension contributions and exploit higher rate relief by transferring some of their Isa funds into a pension. This means the investor receives higher rate relief on all pension contributions, rather than a basic rate.
Once again, flexibility is one of the main advantages. Even if the saver doesn't become a higher rate taxpayer in their lifetime, they still have the advantage of investing their Isa contributions into a pension much later in life. This will allow them to offset the sometimes questionable advantages of pension investment for low earners as opposed to using their Isa savings in retirement.
Therefore, the question should not be why invest in Isas, but why not?
• Neil Lovatt is sales and marketing director at Scottish Friendly
