Cash Q&A: Saving for retirement

I assumed that this would be done with a pension but a friend reckons that an individual savings account (Isa) makes more sense. I’m confused as to which would be best. Can you please point me in the right direction?

FG Aberdeen

A. The easy answer would be that you should endeavour to make a full subscription to both in the current tax year – £11,280 to a stocks and shares Isa (increasing to £11,520 for the 2013-14 tax year) and £50,000 to a pension (falling to £40,000 in the 2014-15 tax year). In reality though, this is not possible for the majority and so there is indeed a decision to be made.

Saving within an Isa does hold some advantages over contributing to a pension. Firstly an Isa can be accessed at any time, whereas pension monies, under current legislation, cannot ordinarily be accessed until you are 55 years old. Conversely though this could be seen as a disadvantage if you have a history of regretfully dipping into your savings.

The second advantage Isas have over pensions is that your entire Isa pot can be accessed free of any personal tax, whereas only 25 per cent of your pension fund will be tax-free, with the rest accessible as taxable income.

However, this advantage is offset (maybe more than offset) by the fact that Isa contributions will be paid out of your post-tax earnings, whereas pension contributions are paid out of your pre-tax earnings. This means that in the 2012-13 tax year a £100 pension contribution will only cost a basic rate tax payer £80 and a higher rate tax-payer just £60.

A final Isa advantage is that if you are currently a basic rate taxpayer but anticipate being a higher rate taxpayer in the future, an Isa could be used to shelter your savings from tax for now and then used to make pension contributions that will receive higher rate tax relief (40 per cent) as opposed to basic rate relief (20 per cent).

If you can take advantage of higher rate tax relief during the accumulation phase and then pay basic-rate tax when you retire, this can be the most effective way to make use of the tax reliefs currently available.

But there are advantages to saving into a pension that don’t apply to Isa savings.

Firstly, your employer might currently match your pension contributions and so this is an excellent way of building up your retirement savings. The annual contribution limit for a pension (currently £50,000) is significantly higher than that for Isas (£11,280).

As well as reducing higher rate tax liability, pension contributions can also be used by higher rate tax payers to reduce, or avoid altogether, the government’s child benefit tax that will come into effect next month. For those earning over £50,000, 1 per cent of child benefit will be lost for every £100 earned over the £50,000 threshold, with the benefit lost entirely for those earning over £60,000.

Net earnings can be reduced by pension contributions to limit the amount within the £50,000 to £60,000 band or take earnings below £50,000. This could be done by beefing up your existing contributions or by salary sacrifice.

The decision as to which you use boils down to your personal circumstances, especially your tax position, and maybe even your discipline as a saver.

One thing for sure is that the government cannot be relied upon to provide a good standard of living in retirement. Starting to save as soon as possible is definitely good advice.

• Mark Thornton-Smith is a financial planner within Cornerstone Asset Management.

If you have a question you need answered, write to Jeff Salway, ℅ The Scotsman, 108 Holyrood Road, Edinburgh EH8 8AS or at [email protected]. The above is for general purposes only and is not tailored for individual use. It does not constitute legal, financial or investment advice on any particular matter and must not be treated as a substitute for specific advice. No action should be taken in reliance of the information given. The Scotsman Publications Ltd and Cornerstone Asset Management accept no liability on the basis of this article.