We are all starting to realise that we'll need to provide for our own retirement if we want a comfortable lifestyle after we leave the workplace. However, although rules around when and how we can take our pensions are becoming more flexible, there are still several reasons why you may be a little unsure of the pensions market.
With auto-enrolment well underway, many people will be enjoying the benefits of company pension schemes. These include contributions from your employer as well as tax relief – there is no better way to save for retirement than this, as you are in effect getting "free" money. But what about when it comes to a private pension or an ISA - which should you put your money into? Here are a few things to consider.
One of the main advantages of a pension over an ISA is that of tax - your pension provider can claim tax back on your contributions. So for every £100 you contribute, you're actually contributing £125 into your pension if you're a basic rate taxpayer. If you pay tax at a higher rate, you can claim the difference through your tax return.
When you retire, your pension payments are subject to income tax in the same way as your employment income. You are likely to be drawing a smaller income, and you may fall below the threshold anyway and will therefore pay no tax.
ISAs are tax-efficient in terms of having your interest or capital gains paid tax-free, but because you'll be paying in money you have earned, you'll already have paid income tax on that amount. However, you could use your ISA to provide an income when you retire, and this will be tax-free.
Another advantage to a pension scheme would be if you were ever made redundant or became unemployed for any reason. Your pension pot does not affect your entitlement to state benefits, whereas an ISA counts towards savings, which can affect your entitlement to certain means-tested benefits.
Depending on the funds in which your pension pot is invested, there is an investment risk with a pension, and your pot has the capacity to fall as well as rise in value. You can normally choose lower-risk funds according to your attitude towards risk, but even with these there is the possibility, albeit a lower one, that the fund you are invested in falls in value.
If you put your money into a cash ISA it will carry no investment risk at all, though it is at risk from the eroding effects of inflation. The only other consideration is if the bank or building society goes bust, but you are protected for up to £85,000 per institution under the Financial Services Compensation Scheme (FSCS). For people seeking a better return from their cash ISA, a stocks & shares ISA may be a consideration, but as with pensions, these involve more investment risk.
You can't currently access your pension pot until the age of 55, but this will be pushed back at the same pace as the State Retirement Age and it will move to age 57 in 2028.
Conversely, when investing in an ISA you can access your money whenever you want, although there may be a penalty for doing so if you've invested in a fixed rate product. However, this freedom could be a downside to saving for retirement if you don't have good willpower, and you should think very carefully about touching the money you have set aside.
Anyone reaching retirement age can take a lump sum of up to 25% of their pension pot tax-free. However, since April 2015 pensioners have had the option to access their entire pension pot, and anything above the tax-free element will be taxed as earned income at the relevant income tax rate.
Another option available to pensioners with a pot is income drawdown, whereby they can take an income directly from their pension pot.
Alternatively, many people may choose to purchase an annuity with their pension pot – a guaranteed income for life. It can seem a big decision to make, but if you research the market properly, then an annuity can offer an unrivalled level of security.
If you have ISA savings, then you can either decide to take an income from the interest or investment returns on your ISA pot, or you could take a portion of the actual pot itself, but you must remember that when you start to eat into the capital in your ISA, the interest you ear will become less.
If you have purchased an annuity, then you will have a guaranteed income for life, but if you have decided to drawdown your income by taking income in excess of investment growth in the fund, then there is a chance it could run out before you die and greatly reduce your income in later life.
When it comes to an ISA, if you are only using the interest or returns from your account, then (depending on investment performance if you choose to leave your pot invested) your income should not run out in your lifetime. If you decide to take a portion of your ISA pot each month or year as an income, it's possible that you could use this up in the same way as in pension drawdown.
When looking at the pension/ISA debate there is no clear-cut answer - your decision depends on many considerations, including your attitude to risk, your own level of willpower and what you want out of your retirement. With the new pension freedoms, there is even less difference between the two, with tax relief on the pension and minimum age at which it can be accessed being the main differences.
Pensions will always win when it comes to tax efficiency – and a company scheme is a no-brainer – but if it is flexibility as to when you can access your money that is important to you, then the ISA comes into its own.
Perhaps it all comes down to the old saying of having your eggs in different baskets, and if you make the most of both products, then you can have the best of both worlds and increase your options when you retire.
Note: This article is intended as a discussion of the relative merits of investing in an ISA or a pension to provide income in retirement. It does not constitute financial advice. If you are unsure of your retirement options, we recommend that you seek the guidance of an independent financial adviser.
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Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.
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