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With a pension scheme, tax benefits are obtained at the start, while with an individual savings account (Isa) the tax benefit is on the money generated by investments.
An employees’ tax position will influence whether or not saving into an Isa, a pension scheme or both is best for them.
In an Isa, staff have continuous access to their money, which is not the case in a pension plan.
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More and more employees are discovering that saving for retirement does not have to revolve solely around a pension scheme. With individual savings accounts (Isas) also offering tax benefits, these are becoming an increasingly popular retirement planning tool, but are they a viable alternative?
Ryan Hughes, investment manager at financial advisers Chartwell Investment Management, attributes Isas’ increasing attractiveness to the sense of control they afford: "People still do not like the idea of being compelled to purchase an annuity. They think they understand Isas better," he suggests.
While the tax benefits of a pension come when money is paid into it, and the tax incurred when the investment is drawn on, in an Isa the tax relief falls on the growth element.
The two also differ in that savings in a pension plan are locked away until retirement, whereas an Isa can be accessed at any time. This provides greater flexibility, but also means discipline is needed to ensure funds are not diverted to an expensive holiday or a new car.
Because of the nature of the tax benefits of each, basic rate taxpayers can gain flexibility benefits by saving into an Isa until they hit the higher rate tax bracket before moving their savings across to a pension. If someone is a higher rate taxpayer now, for example, they are unlikely to be upon retirement and will therefore only have to pay the lower tax rate when they draw on their pension.
But Towry Law’s employee benefits consultant Iain Henshall, points out that while using Isas for pension savings is feasible on an individual basis, this is not necessarily the case at group level. While large organisations might be able to get a provider on side to set up a group scheme, it could prove difficult for smaller organisations. Also, only employees can pay into an Isa.
"If [organisations] are trying to run an Isa scheme, how do they collect the contributions and pay it over to the providers? [For many organisations] it isn’t an alternative," says Henshall.
He also cautions that Isas are subject to change. To date, we can only be sure Isas will exist until 2010, putting a question mark over their long-term viability as an alternative. Other factors to consider include the ability to contribute more to a pension scheme than to Isas, maximising employer contributions and the 25% tax-free pensions’ lump sum.
James Jones Tinsley, head of pensions at Bates Investment Services, explains: "Both of them have their own distinct advantages over each other. If someone is in a position to do both, that would be the ideal." Otherwise, if a budget is not conducive to doing so, Isas need to be weighed up against a stakeholder pension, which offers similar transparency and charges.