Despite many tax changes on the way, pensions are still the best way to save for retirement, according to a new report.
Pensions are still the most tax-efficient way to save, despite the big tax changes coming in the new financial year, according to the Institute for Fiscal Studies (IFS).
The IFS compared the returns from saving into a pension with alternatives including buying a house, investing in a stocks and shares ISA and becoming a buy-to-let landlord.
Why pensions are the best option
Pensions were the big winners, because they are subject to a number of tax advantages. Firstly, your pension contributions are taken out of your untaxed income. As a result, paying into a pension will actually lower your Income Tax bill. What's more, the returns on your investments are not taxed (though you will pay tax on withdrawals).
And don't forget that you can take 25% of your pension pot as a lump sum, without having to pay a penny in tax. In the words of the IFS: "pension saving is in effect subsidised".
On top of this, the auto-enrolment system now requires employers to match employee pension contributions up to a certain level. “Since employers rarely make equivalent offers to match employees’ contributions to say an ISA or a house, it makes savings in a pension much more attractive relative to other assets,” says the report.
The employer contributions are also not subject to National Insurance contributions. For a basic-rate taxpayer this means “a contribution to a pension by their employer with a net cost of £70 is worth the same as a £100 contribution to an ISA,” says the report.
Tax changes make no difference
Pensions came out on top despite a number of changes to the ways savings are taxed from this April. There is the new personal savings allowance, which will allow basic rate taxpayers to enjoy up to £1,000 of interest from their savings absolutely tax free. Higher-rate taxpayers are allowed £500.
This will mean 16 million people will stop paying any interest on their savings income, says the IFS, and 95% of people will no longer have their savings taxed.
“The last few years have seen radical changes announced to the taxation of savings,” says Stuart Adam, one of the report’s authors. “These will take millions of people’s savings out of the tax net altogether.”
And then there are the changes to the way dividends are taxed, meaning you will not pay tax on the first £5,000 of your dividend income.
Forget buy-to-let, buy a bigger house
The research also found that those people wanting to invest in property will make a far more tax-efficient move by investing in their own home, rather than by becoming buy-to-let landlords.
“Investment in owner-occupied housing is significantly more tax-advantaged than investment in property to let, even before recently announced changes to the treatment of mortgage interest for landlords,” says the report.
Pension changes on the way
Of course, there has been plenty of talk about further changes to pensions which will be announced in the Budget next month. It appears increasingly likely that the Government will move towards a flat system of tax relief on the contributions we make into our pension, rather than the current system where the relief you enjoy depends on your tax bracket. The existing set up favours higher and additional rate taxpayers, as they enjoy greater tax relief on their contributions.
The current thinking seems to be that the Government will set a flat rate of somewhere around 30%. This will actually represent a further boost to pension saving for basic rate taxpayers, who currently enjoy tax relief of 20% on their contributions, but will dent the appeal of pensions to higher rate and additional rate taxpayers who enjoy tax relief of 40% and 45% at the moment.
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