By Rachel Wait
All of us need to save more for our retirement. As more of us live to a ripe old age, it's more important than ever to build up a savings pot to live off once we've given up work.
Saving into a pension is one option. But not everyone agrees that using a pension is the best way to build up a retirement fund, with many believing the returns are too poor. Another option is an Isa. So let's take a closer look at some of the differences between them.
Pensions
Tax
One of the major advantages of a pension is tax relief. If you're a basic rate taxpayer paying into an individual personal pension scheme, your pension provider will claim back the tax from the government at the basic rate of 20%. This means that for every £80 you pay in, your total contribution will be £100. And if you're a higher rate taxpayer (40%) or an additional rate taxpayer (50%) you can claim the difference through your tax return.
It works slightly differently if you have a company pension. Here, your employer will take the pension contributions from your pay before deducting tax (but not National Insurance contributions). This means you only pay tax on the remainder of your salary.
When you come to retire and you want to get access to your pension, you can take a 25% tax-free cash lump sum. After that, the money you take out or receive from your annuity will be taxed at your highest rate of tax – so if you are a higher rate taxpayer, you'll be taxed at 40%. That said, if you were a higher rate taxpayer during your working life and become a basic rate taxpayer when you retire, you won't lose out as much.
Access
At the moment, the earliest you can access your pension is at the age of 55. Although there has been a lot of debate over whether savers should be allowed to get their hands on their funds earlier, this has been ruled out for the moment. Many people are therefore put off contributing to a pension because they are concerned they will need that money before they reach the age of 55. But the advantage of leaving your money untouched is that it has plenty of time to grow.
Contributions
The maximum amount you can pay into a pension scheme and still receive tax relief is 100% of your earnings or £3,600, whichever is greater. This is capped at an annual allowance which is £50,000 for the current 2011/12 tax year.
If you have a money purchase pension scheme, your employer may also contribute to your pension. Many employers will match your contributions up to a certain level, say 5%. This is a major advantage as it will help you to build up a more substantial pension pot. Remember that your annual allowance includes any employer contributions and the tax relief you receive.
Risks
One of the main concerns with investing in a pension is that it is risky. After all, you're investing in the stock market which can go down as well as up – and at the moment, it's generally moving in a downwards direction. It's therefore important to avoid putting all of your eggs in one basket so that should one sector collapse you have other investments to fall back on.
If you have a company pension scheme and your employer goes bust, your investments should still be safe as they will have been held separately. Final salary schemes are riskier, but if your company can't cover your pension fund, the Pension Protection Fund will pay out your entire pension fund if you've reached retirement age or no less than 90% if you haven't.
Reaching retirement
Once you reach retirement you will have the option to buy an annuity which provides an income for the rest of your life. However, annuity rates can be disappointingly low so in order to get the best rates, it's vital that you shop around. You don't have to buy an annuity from the pension company where yourfund is held. If you suffer from various medical conditions you may qualify for an impaired life annuity which pays out more.
Another option is income drawdown where you take an income from your pension fund while the fund remains invested. However, while this can prove beneficial, if the market falls, you will lose out.
Isas
Tax
With an Isa, you won't receive any tax relief on your contributions. However, there are still tax benefits. For cash Isas, you won't be taxed on the interest you earn, while for stocks and shares Isas you won't have to pay Capital Gains Tax (CGT). Outside an Isa, if you make gains of more than £10,600 from the sale of shares and certain other assets in the tax year 2011/12, you would have to pay CGT.
Access
Access is much less restricted than a pension as you can access your funds whenever you want (unless you have a fixed-rate cash Isa where you will need to wait until the term ends). Be warned though that if you withdraw money from your Isa and you've already used up your allowance for that tax year, you won't be able to pay any more money in until the new tax year.
Of course, having access to your money also means you could be tempted to spend it before you reach retirement.
Contributions
How much you can pay into an Isa is more restricted than for a pension. For the 2011/12 tax year you can pay in a total of £10,680. Of this, up to £5,340 can be invested in a cash Isa. However, you can invest the full amount into stocks and shares if you want to. In the 2012/13 tax year, these limits are rising to £11,280 in total or £5,640 for a cash Isa.
Risks
If you invest in a stocks and shares Isa, you'll again be investing in the stock market. So it's important you diversify your portfolio. If, on the other hand, you're investing in a cash Isa, you will be relying on interest rates to be high – and as savers will know, high interest rates are currently a thing of the past.
Should your bank go bust, the first £85,000 of your savings in a cash Isa will be protected under the Financial Services Compensation Scheme. This is per institution so if you have savings in more than one bank, £85,000 will be protected in each (providing they don't share a banking licence). With a stocks and shares Isa, you'll be protected up to £50,000, but this only applies if your Isa provider goes bust - not if your investment performs badly.
Reaching retirement
As you can get your hands on your money whenever you choose to with an Isa, the money is simply yours to use when you come to retirement. It's completely up to you how much you choose to withdraw and when.
Pension or Isa?
Ultimately, it's up to you whether you want to invest in a pension or an Isa and there are a number of pros and cons for each. Of course, there's absolutely nothing stopping you from saving in both, but the main thing is that you're taking steps to prepare for your retirement.
