In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at money@inews.co.uk.
Question: I’m in my fifties and saving for my retirement. I know ISAs are a good tax-wrapper and try to save a bit in them each year alongside my workplace pension. How can I make the best use of them to save for my retirement and will the new British ISA announced earlier this year make them more useful?
Answer: Let’s kick off by setting out how ISAs and pensions work. You can pay up to £20,000 a year into an ISA, with different versions available depending on what you want to invest in. The main versions are cash ISAs, which pay you an interest rate in a similar way to a bank account, and stocks and shares ISAs, which allow you to invest your money for the long-term. Once your money is in an ISA, it is sheltered from income tax and capital gains tax, and your money can be accessed flexibly at any time.
If you are aged 18-39, you also have the option of paying up to £4,000 a year into a ‘Lifetime ISA’ (LISA), with the government adding a 25 per cent bonus worth up to £1,000 a year on top. This forms part of your overall £20,000 yearly ISA allowance. You can keep paying into a LISA and receiving the government bonus until your 50th birthday.
Once your money is in a LISA, it enjoys the same tax benefits as cash ISAs and stocks and shares ISAs, and can be accessed tax-free from age 60, if you use it towards a deposit on a first home worth £450,000 or less, or if you become terminally ill. In all other circumstances the Government will apply a 25 per cent charge to the funds you withdraw, meaning you might get back less than you originally put in.
The rules around how much you can save in a pension are a bit more complicated. You can personally contribute up to 100 per cent of your earnings to a pension each tax year, with an overall “annual allowance” of £60,000 applying to most people.
If you have no earnings, you can pay up to £3,600 into a pension each year. If you have very high earnings then you might be affected by the annual allowance ‘taper’, which can reduce your annual allowance as low as £10,000. In addition, if you have flexibly accessed taxable income from your pension (for example, through ‘drawdown), your annual allowance is reduced to £10,000.
Those limits are in place for a reason: namely because pensions offer excellent incentives to save for retirement. You get upfront basic rate tax relief on your contributions, meaning you receive an automatic 25 per cent boost when you pay into a pension. Higher and additional-rate taxpayers can also reclaim extra pension tax relief from HMRC. Your money can also grow completely free of tax, just like an ISA. You can access your pension from age 55, with up to a quarter available tax-free and the rest taxed in the same way as income. This minimum access age is due to rise to age 57 in 2028.
ISA or pension?
Your first port of call should be your workplace pension, as this comes with both tax relief and employer contributions too. For savings over and above this, you should think about your medium and long-term financial goals, the retirement lifestyle you hope to enjoy and how much money you are prepared to lock away. Lots of people choose to invest in both pensions and ISAs as part of a balanced long-term savings strategy.
The Lifetime ISA sits somewhere between ISAs and pensions, although it is complicated by the government exit penalty. It is certainly a good option if you’re saving for a first home and is also worth considering as a retirement savings vehicle if you are a basic-rate taxpayer, as the bonus is identical to a pension and the money can be accessed tax-free. From a pure tax perspective, higher and additional-rate taxpayers would get a bigger bang for their buck from a pension.
One other thing to consider is inheritance tax (IHT). Pensions are usually free of IHT and can be passed on entirely tax-free if you die before age 75. If you die after age 75, your beneficiary (or beneficiaries) will be taxed in the same way as income when they access the money. ISAs, on the other hand, will form part of your estate for IHT purposes, meaning your money could be taxed at 40 per cent if you have used up your allowances.
The British ISA does not exist yet, so is not something you can take into account at the moment. The Government has proposed a £5,000 limit for the British ISA, which would be on top of the £20,000 limit that currently applies to other ISAs. Investors would be restricted to investing in UK companies through the proposed British ISA (and possibly UK-focused investment vehicles), although this and other rules have yet to be defined.
If we get more details on the British ISA, I’ll return to it in detail in a future column.