Pension ISAs – better or worse?

Yet another radical shake-up of pensions has been proposed, which the media are dubbing the ‘Pension ISA’. It’s had a warm welcome in some quarters, but a very cool one in others. Would it really improve on the current system? We look at how it might work.

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A recent survey by accountancy firm PwC found that 40 per cent of people (in a sample of 1,200 workers) were in favour of a proposed new system of ‘pension ISAs’, and that only 27 per cent considered the current system to be superior. As findings go, that’s pretty decisive. But what exactly were these people voting for?

What is a pension ISA?

Actually, stop – go back. Before explaining what a pension ISA is (or might be), we need to recap how a pension works now.

How a pension works now

Pension savings currently benefit from tax relief, so that the money you pay in is boosted as if you’d never paid tax on it in the first place. This happens at your marginal rate of tax, so if you’re a basic rate taxpayer, a payment of £8 would turn into £10 (because £10 taxed at 20 per cent is £8). This may be one of the hardest things to understand about pensions – the good news is, it’s also one of the best. In short: paying into a pension gives you quite a lot of extra money.

Okay, so what is a pension ISA?

Hold on one more minute. First we need to talk about the downside of the current pension system.

The downside of the current pension system

Although you get tax relief when you pay into a pension, you can still be taxed when you withdraw your savings. How much you’re taxed depends on (among other things) how much you take out per year – you can reduce this tax if you keep to modest withdrawals, but if you want to access large sums then be prepared to take a tax hit.

The current system has also been criticised for being unfair. Because people get tax relief at their marginal rate, it means that higher-rate taxpayers receive 40 per cent relief on pension contributions. So to get that £10 in their pot, they’d only need to pay in £6. The accusation is that this favours the wealthy over the less well-off.

Okay, got it. Seriously though, what is a pension ISA?

Right. The proposal (and it is still just a proposal) is to make pensions work much more like ISAs. There would be no more tax relief on payments into them, but instead withdrawals would be tax free. It appears that this detail – tax free withdrawals – is the one that has been seized upon by those who like the idea. Pension ISAs hold a strong appeal for those who want to access big sums of money in one go. The bias towards wealthier savers is also, arguably, reduced.

Is there a downside?

Many people are saying so (including pensions minister Ros Altmann herself). Those against the idea point out that tax relief on contributions results in a far larger pension pot by retirement age, because of all that extra money accumulating compound interest over time. Having tax relief just at the end of the process could mean the loss of tens of thousands of pounds of additional interest. Another objection is that, once you’ve got tax relief on a pension contribution, that money is yours – but with a pension ISA, you’d have to rely on some future chancellor honouring the policy not to tax your withdrawals. It’s a big gamble on which to stake your life savings.

Did the voters in the PwC survey understand all this?

Maybe some did, but it seems doubtful. It’s another demonstration of how important it is know exactly how your pension works, and to take financial advice on maximising your income in retirement. In the meantime, we must wait and see whether pension ISAs will really come to pass.

To find out whether your current pension could be improved upon, book a free pension check with a regulated adviser at unbiased.co.uk.