Pensions 'best way to save', say IFS

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PENSIONS remain the most tax efficient way to save, regardless of recent tax changes and proposed reforms, say the Institute of Fiscal Studies (IFS).

The IFS compared various forms of saving, such as bank accounts, pensions, property, shares and Individual Savings Accounts (ISAs).

Furthermore, the report's authors added that while personal pensions offer us the best returns in tax terms, workplace pensions have the potential to be even better.

Because employers must match employee contributions under the auto-enrolment programme, this form of saving is "much more attractive than almost any other option".

All change

The IFS report [pdf] says that basic rate taxpayers stand to gain again if the Government go through with plans to replace variable tax relief on pension contributions with a single, flat rate.

At the moment, savers receive pensions tax relief at the highest rate of tax that they pay - so basic rate taxpayers receive 20% tax relief, while higher rate taxpayers receive 40%, and the highest earners who pay the additional rate get 45% relief.

Under the new flat rate system, everyone would receive relief at what's expected to be 25%.

Say, for example, we have a basic rate taxpayer who pays £10,000 into their pension fund. At the moment they'd see that contribution boosted by £2,000 in tax relief.

A higher rate taxpayer (someone earning more than £42,385) would receive £4,000 in relief.

Under the proposed 25% flat rate they'd both receive £2,500 - an improvement of £500 for the basic rate taxpayer, but a considerable decrease for the higher rate taxpayer.

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The IFS report suggests that if this flat rate is introduced, higher rate taxpayers "would be better off saving for their retirement via an ISA or a more expensive home."

They say "more expensive home" rather than "second" or "additional home" because there are more tax advantages to having a home that we use as our own, main, residence than there are in second homes and buy-to-let properties.

These advantages will become further pronounced when changes to the tax relief on mortgage interest come into effect in 2017.

The reforms will reduce the 40% relief for higher rate taxpayers down to 20% - which the IFS say will "weaken the incentive" for people to get into the buy-to-let property market.

Some critics have warned that this will cause private rental prices to rise even further, with landlords trying to make up for their losses by charging their tenants more.

Modest incomes

At the other end of the spectrum, the IFS report explains how the introduction of Universal Credit could impact on the savings habits of those who claim or are thinking of claiming the benefit.

Under Universal Credit, anyone who has more than £6,000 in liquid savings of some sort - whether in an ISA or other accessible account - will see how much they can claim in benefits reduced. For every £250 extra they have, their benefit will be cut by £4.35 a month.

Anyone with more than £16,000 saved will find themselves ineligible to claim.

But while saving in an easily accessible form isn't all that attractive for Universal Credit claimants, those who can afford to put money into a pension may find it pays off.

Basic rate taxpayers will find that for every pound they make in pension contributions "increases Universal Credit entitlement by 52p".

The obvious issue here, as the report points out, is that "times when people need means tested support may not be times when they have money available to save".

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Claimants who don't have £6,000 or more in savings - and everyone else, for that matter - will still benefit from another change to the tax rules, in the form of the Government's new Personal Savings Allowance (PSA).

From April 6 2016, every basic rate taxpayer will be able to earn up to £1,000 a year in interest before they have to pay tax on it; higher rate taxpayers will be able to earn £500 before tax is levied.

The definition of "savings" covers everything from the money held in current and savings accounts with banks, building societies and credit union, to gilts and money invested in peer-to-peer lending.

The result of this, say the IFS, is that 95% of people will no longer have their savings taxed - which means we'll get the full amount of interest quoted. For many smaller savers the incentive to put money in an ISA will therefore disappear:

"For most people, the ordinary bank account will in effect be tax free in much the same way as cash ISAs."

With ISA interest rates being so low, and with some current and standard savings accounts offering higher rates of interest than ISAs - and with that interest being tax-free from April - there are predictions that more of us will move away from ISAs.

Saving for the future

For those of us who want to save long term, though, the message from the IFS is clear - put our money into a pension.

As well as being tax efficient, it's necessary in a population where life expectancy has continued to rise but our willingness to work - or employers' willingness to employ older people - hasn't kept up.

There are more determined efforts to get more of us to save in this way than previously as well - as we mentioned at the beginning, workplace pensions of the sort being rolled out under auto-enrolment are even better than personal pensions.

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