Pensions vs ISAs: what's best for savers now?

Flower pots being watered with investment labels.

The rules that govern pensions and individual savings accounts (ISAs) have undergone a radical shift but which one should you choose in the new world of savings?

When looking at the merits of ISAs and pensions, savers must consider tax, accessibility and contributions to decide which wrapper suits their financial needs best.

Tax

ISAs are a very popular way to save as any returns or interest made on money invested through them is tax-free and money can be withdrawn tax-free.

The big difference with pensions is while ISAs are tax-free on money out, pensions offer the tax break on the way in.

Pension contributions receive tax relief, which is essentially free money from the government. For every contributions made, the government will give another 20%, 40% or 45% on top depending on the top rate of income tax paid.

This means a basic rate taxpayer paying £80 into a pension will receive another £20 on top, making the contribution worth £100. Gains and income received on pensions investments is also rolled up tax-free.

Pensions are hit with tax on the way out apart from the allowable 25% tax-free lump sum. When an income is taken from a pension on retirement, either through 'drawdown' or buying an annuity that income is taxed, just as income is taxed in working life.

Adrian Walker, a retirement expert at Old Mutual, said most pensioners pay 20% income tax, so the tax relief is even more beneficial to those paying higher rate tax now. Those people receive 40% tax relief but pay 20% income tax in retirement.

"It is highly unlikely you will be a 40% taxpayer in retirement, so you get 25% out [of you pension] tax free and pay 20% on rest," he said.

However he said those wanting to take lump sums out of their savings may be better offer using ISAs because there will be no tax to pay but someone taking a large amount out of a pension could push themselves into the 40% income tax bracket.

Paying in

The ISA allowance was increased considerably in the last Budget, from £11,520 to £15,000 a year. Aside from the surprise rise in the allowance, the chancellor changed how the money can be changed inside the ISA. Previously, the full allowance could be saved into a stocks and shares ISA or half the amount could be saved in a cash ISA.

However, the whole £15,000 can be saved in a cash ISA now or split between a stocks and shares ISA in any way the saver wishes. Additionally, savers can now transfer from stocks and shares back into cash whereas previously the transfer could only be done from cash to stocks and shares.

Pensions have a larger allowance, with investors able to save a total of £40,000 a year or £1.25 million over a lifetime.

Not only is the pension allowance much larger than the ISA allowance, thanks to auto-enrolment all employers will have to pay into a pension so workers receive an extra savings boost.

Accessibility

ISAs are a popular way to save because the money is easily accessible; money put in can be taken out at any time, although doing so means it cannot be paid back in above the £15,000 annual limit.

When the money is withdrawn it can be taken out as income or as a lump sum, however the individual wants to take it.

Pensions on the other hand are inaccessible until age 55 and that age is due to increase to 57. Despite having to wait for the cash, the new pension freedoms mean that when a saver does they have a lot more options.

Now pensioners can take their pension savings as a cash lump sum, less of any income tax due, or they can put it in 'drawdown' where it remains invested and they take an income from it. Alternatively, they can go via the more traditional route and buy an annuity.

"People need to think about financial planning; are you putting your money away from the long term, or will you want access before age 57," said Walker. "If you want access then I would use an ISA because young people will be locked out [of their pension savings] until at least 57 and maybe even longer."

On death

The tax treatment on death for both ISAs and pensions has been changed recently. ISAs can now be passed to a spouse while being kept out of the inheritance tax (IHT) net which is a bonus.

However, pensions have been made even more attractive from an IHT point of view. The government has abolished the 55% death tax on pensions if a saver dies before 75 and reduced it to 45% if a person dies after age 75 and the money is taken as a lump sum – this figure will reduce to the beneficiary's rate of income tax in 2016.

For beneficiaries who take the pension as an income, it will be taxed at their income rate.

In further good news, the pension can be left to anyone a person likes, not just a spouse or a child aged under 23.

"If you are putting money away then part of it does need to be put away for the long term but think also about the way money can be taken out...ISAs are best for accessibility but pension pensions work on tax breaks," said Walker.

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If, like many Britons, you have failed to save the cash you need to maintain a comfortable standard of living in retirement, one option is to sell your home and downsize to a smaller property, using the money leftover to cover your living costs.
If moving out of the family home is too much of a wrench, however, the good news is that equity release schemes allow you to stay in your house or flat while still using the equity built up in it to provide some extra cash. The downside of the schemes, which work a bit like mortgages, is that you may not have much left to pass on to any children or other relatives.
But that's a small price to pay for a reasonable standard of living. For more information, try Age UK on 0800 169 6565.

Choosing the right annuity can have a significant impact on your retirement income. And as with most pensions, you automatically have what's called an 'open-market option' (OMO), you can scour the market for the highest annuity rate.
It is worth checking what your pension provider is offering first, though, as some companies offer guaranteed rates for existing customers that are likely to beat those available elsewhere. The Pensions Advisory Service on 0300 123 1047 is a good place to get some free advice.

On retirement, most people convert their pension fund into a guaranteed income annuity that pays out the same amount every month for the rest of their lives.
However, you can also choose an increasing annuity that pays out smaller amounts in the first few years but offers larger payments further down the line. This may prove a wise move if the rate of inflation remains at over 2%.

It is now easier to work later in life because the "default retirement age" has been scrapped.
People approaching retirement age and worrying about money can therefore choose to work for a few years longer - potentially transforming their financial situation. Other than the extra income from working, these people can look forward to higher state pensions, and higher annuity rates due to their greater age.
They can also benefit from bigger tax allowances and the fact that they no longer have to pay National Insurance contributions. Check out this nidirect website for more details.

You could get a much better rate with an impaired-life annuity if you have a medical condition that is likely to reduce your life expectancy.
Incredibly, even snoring, which is a common symptom of Sleep Apnoea could have an impact.
According to figures from MGM Advantage, a man with this condition could receive an extra £12,000 retirement income over the course of their retirement - or £571.44 extra money each year. Click here to find out more.

To maximise your retirement income, it is vital to ensure that you are receiving all the benefits to which you are entitled. These include the basic State Pension, and in some cases, the additional State Pension.
If you are on a low income, you could also qualify for the guaranteed element of Pension Credit, while those with some savings may get the savings element of this benefit. For more information about these and other benefits such as the Winter Fuel Payment, click here.

Many older couples rely on the pension income of one person - often the man. Should that person die first, the other person can therefore be left in a difficult position financially.
One way to prevent financial hardship for the surviving person is to take out a joint life annuity that will continue to pay out up to 67% of the original payments to the surviving partner should one of them die.
The disadvantage of this approach, however, is that the rate you receive will be lower. Again, the Pensions Advisory Service on 0845 601 2923 is a useful first port of call if you are unsure what to do.

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Read more:
New pension rules: how to avoid a huge tax bill

Pension changes 2015: 45% tax sting for those who cash in pension

Budget 2014: a cap on ISAs would be the final insult to savers

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Figures from charity Age UK show that 29% of those over 60 feel uncertain or negative about their current financial situation - with millions facing poverty and hardship. Even though saving for retirement is not much fun, the message is therefore that having to rely on dwindling state benefits in retirement is even less so. To avoid ending up in this situation, adviser Hargreaves Lansdown recommends saving a proportion of your salary equal to half your age at the time of starting a pension. In other words, if you are 30 when you start a pension, you should put in 15% throughout your working life. If you start at 24, saving 12% of your salary a year should produce a similar return.
Many older couples rely on the pension income of one person - often the man. Should that person die first, the other person can therefore be left in a difficult position financially.
One way to prevent financial hardship for the surviving person is to take out a joint life annuity that will continue to pay out up to 67% of the original payments to the surviving partner should one of them die.

The disadvantage of this approach, however, is that the rate you receive will be lower. Again, the Pensions Advisory Service on 0845 601 2923 is a useful first port of call if you are unsure what to do.

Around 427,000 households in the over-70 age groups are either three months behind with a debt repayment or subject to some form of debt action such as insolvency, according to the Consumer Credit Counselling Service (CCCS).

Its figures also show that those aged 60 or older who came to the CCCS for help last year owed an average of £22,330. Whether you are retired or not, the best way to tackle debt problems is head on.

Free counselling services from the likes of CCCS and Citizens Advice can help with budgeting and dealing with creditors.

Importantly, they can also conduct a welfare benefits check to make sure you are receiving the pension credit, housing and council tax benefits, attendance and disability living allowances you are entitled to.

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The average UK pensioner household faces a £111,400 tax bill in retirement as increasing longevity means pensioners are living on average up to 19 years past the age of 65, according to figures from MetLife. And every year in retirement adds an extra £5,864 in direct and indirect taxes based on current tax rates to the costs for the average pensioner household. You can be forced to go bankrupt if you fail to pay your taxes, so it is vital to factor these costs into your retirement planning.It is also important to check that you are receiving all the benefits and tax breaks you are entitled to if you want to make the most of your retirement cash.

The cost of a room in a care home in many parts of the country is now over £30,000 a year, according to figures from Prestige Nursing and Care. So even if the prime minister announces a cap on care costs - last year the economist Andrew Dilnot called for a new system of funding which would mean that no one would pay more than £35,000 for lifetime care - families will still face huge accommodation costs. Ways to cut this cost include opting for home care rather than a care home. Jonathan Bruce, managing director of Prestige Nursing and Care, said: "For older people who may need care in the shorter term, home care is an option which allows people to maintain their independence for longer while living in their own home and should be included in the cap." However, the only other answer is to save more while you can.
Older Britons are often targeted by unscrupulous criminals - especially if they have a bit of money put away. For example, many over 50s were victims of the so-called courier scam that tricked into keying their pin numbers into their phones and handing their cards to "couriers" who visited their homes. It parted consumers from £1.5 million in under two years. Detective Chief Inspector Paul Barnard, head of the bank sponsored dedicated cheque and plastic crime unit (DCPCU), said: "Many of us feel confident that we can spot fraudsters, but this type of crime can be sophisticated and could happen to anyone." The same is true of boiler room scams that target wealthier Britons with money to invest, offering "once-in-a-lifetime" opportunities to snap up shares at bargain prices. Tactics to watch out for include cold calling, putting you under pressure to pay up or lose the opportunity for good, and claiming to have insider information that they are prepared to share with you.
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