Isas and pensions are both tax-efficient, but that is not to say they are the same, explains Steve Bee, founder and chief executive of JargonFreeBenefits.
Pensions are tax-efficient and complex. Isas are tax-efficient and simple to understand. Those two sentences sum up many of the acres of newsprint you will find in the financial press every year; the implication usually being that Isas are a better bet for retirement savings than pensions because they are simpler and thus easier to understand.
It is a compelling argument, but a wrong one. Isas and pensions are both tax-efficient, but that is not to say they are the same.
To explain the difference, we need to use a little jargon. The tax breaks on pensions are described as "EET". What this means is that the money paid into a pension is exempt from tax (the first E) and the pension fund investments are also (largely) exempt from tax (the second E), but the output , the pension when it is eventually paid, is taxed as income (the final T).
In essence, when you save money into a pension the deal with the Government is that you pay tax only once on that money, and that is when it is drawn as income. Given the long-term nature of pension saving, that means the gross value of the savings made can benefit from the magic of compound interest. That is a genuine advantage to long-term investments.
In practice, this means that a basic-rate taxpayer will be credited with £100 for every £80 saved, a 40pc taxpayer would need to save just £60 and a 50pc taxpayer could put aside just £50 for a £100 investment. People who are not basic-rate taxpayers need to make a claim for some of their tax relief, but the principle is straightforward.
An aspect of pensions that should not be overlooked is the tax-free cash. Generally speaking, 25pc of a pension pot may be taken as a tax-free cash sum once people reach 55. That means that 25pc of the investment is "EEE" exempt input, exempt investment returns and exempt output.
That is an amazing structure. It has been part of our pension system for decades, and we are so used to it that I think we have lost sight of how powerful it is.
Isas are also tax-efficient, but in a different way. An Isa is described by the acronym "TEE" (taxed input, exempt investment returns and exempt output). They are very popular because the tax-exempt investment returns mean that they should have no trouble beating ordinary saving accounts, for example, which are TTE in structure (taxed input, taxed investment returns and exempt output).
Isa money can be invested in cash, up to certain limits (£5,640 this year), but may also be invested in much longer-term investments, such as equities. This is where they draw comparisons with pensions, but a TEE structure is no real match for an EET structure with 25pc EEE over the long term.
When comparing Isas with pensions, it is easy to overlook the fact that a £100 pension investment does not leave your pocket £100 lighter, as an Isa investment would. A basic-rate pension saver investing £80 in a pension and gaining a £100 investment could invest the extra £20 in an Isa and achieve even more tax efficiency.
Higher-rate taxpayers could build up substantial additional Isa investments alongside their pension savings by doing so and, if kept for the long term, could add substantially to both the value and flexibility of their savings for retirement.
I would like to see the Government look carefully at our pension and Isa tax laws and consider whether investors might be better served by a new long-term savings product that combines the best elements of the two. The argument should not be about whether pensions are better than Isas, but about whether the best aspects of both structures access to cash when needed and the benefit of compound interest for long-term investments could be melded into one.
Steve Bee is the founder and chief executive of JargonFreeBenefits