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This year sees some significant changes to pensions and Individual Savings Accounts (ISAs); both popular retirement planning vehicles.

Higher earners saw their ability to get full income tax relief on pension contributions attacked in the 2009 Budget. New ‘anti-forestalling’ measures were introduced which restrict the level of higher rate income tax relief on offer for some investors. In simple terms, people earning over £150,000 in this or either of the previous two tax years face tax relief limits on pension contributions over £20,000 (or slightly higher in certain circumstances).

This year also sees the ISA contribution allowance increased from £7,200 to £10,200. The new limit comes into force from 6th October 2009 for investors who have reached their 50th birthday ahead of 6th April 2010. For the rest of us the ISA allowance goes up to £10,200 from the start of the 2010/11 tax year.

Pensions and ISAs have some different features, particularly when it comes to the tax treatment of contributions and eventual benefits. Deciding on what works best as a tool for your retirement planning depends on your personal circumstances, goals and objectives.

Here is a quick guide to some of the main features to consider. Let battle commence.

Tax relief on contributions

A key difference between pensions and ISAs is the tax relief each receive on the contributions. Whilst contributions to a UK registered pension scheme are usually eligible for income tax relief, investments into an ISA do not get these generous tax breaks.

Assuming you have sufficient earnings to justify the contribution (more on that later), your pension contributions should result in income tax relief at your highest rate of income tax, with a minimum of basic rate income tax relief added. This means that non-taxpayers and basic rate taxpayers get 20% tax relief added directly to their pension fund. Higher rate taxpayers are then able to reclaim the difference between basic and higher rate income tax (currently an additional 20%) as additional tax relief.

This income tax relief on pension contributions gives the pension route to retirement planning a big head start. It means that a pension investor can afford to take more risk with their money, as a 20% or 40% short-term fall in fund values would simply take them back to the starting point equivalent to an ISA investment. Of course these tax breaks on contributions come at a price.

Contribution limits

With pensions, you can contribute up to 100% of your earnings in a given tax year and receive income tax relief on the whole lot. This is subject to a couple of restrictions.

There is an annual allowance which limits the maximum pension contribution you can make in a tax year. This is £245,000 for the 2009/10 tax year, so unlikely to bother the vast majority of investors.

Since the 2009 Budget there has also been a special annual allowance which applies to pension contributions made by ‘high earners’; people with ‘relevant earnings’ of more than £150,000 in this or either of the previous two tax years. This is a basic allowance of £20,000 or an enhanced allowance of up to £30,000 where previous pension contribution levels can justify this higher amount.

Investors with no income can still contribute up to £3,600 each year into a pension and receive basic rate income tax relief. Remember that these figures are all ‘gross’ contributions after the addition of basic rate income tax relief.

The investment limit for ISA investors is currently £7,200. This is set to rise to £10,200 each tax year from 6th April 2010, or from 6th October 2009 for people who are 50 or older by the end of the 2009/10 tax year.

Of this ISA allowance, up to half (so £3,600 or £5,100) can go into the cash ISA component, with the balance available to invest in the stocks & shares ISA component. You can choose how much of the overall ISA allowance (up to half) to invest in cash.

Tax treatment of the fund

This is one area where pensions and ISAs are broadly neutral.

The money invested within a pension fund or an ISA fund is generally free of income tax and capital gains tax. The one exception to this is the dividend income from UK company shares. This dividend income comes with a 10% tax credit (which means it has already been taxed). You cannot reclaim this tax credit within the pension or ISA.

A difference in tax treatment of the funds does exist when it comes to inheritance tax (IHT). In the event of your death before taking retirement benefits, a pension fund is generally free from inheritance tax at 40% because it can remain outside of your estate for tax purposes.

The ISA tax wrapper ends automatically on death and the assets are included within your estate for IHT purposes. This means that if your total assets exceed the nil rate band (£325,000 for the 2009/10 tax year) then the balance is subject to tax. Married couples can effectively double this nil-rate band on the second death, if the first spouse to die does not utilise their own nil-rate band.

Range of funds

This is another area where pensions and ISAs are broadly similar, although much will depend on the particular product you select. Some pension plans, including many Stakeholder pensions, will offer only a limited range of investment funds from which to choose. Personal pensions now increasingly offer access to a wider range of funds from third-party external fund managers.

The widest range of pension investment options comes from using a Self Invested Personal Pension (SIPP). These enable to you access any investment permitted by HM Revenue & Customs rules, although some pension providers impose additional restrictions on investment choice.

With an ISA, the main choice in ‘product’ is between an ISA from an individual fund manager or an ISA from a fund supermarket. The former might only offer funds from that single fund manager whilst the fund supermarket will offer access to investment funds from a wide range of fund managers. Self Invested ISA products are also available, offering similar investment choice to a SIPP.

Access to the money

Actually getting your hands on your money again is an area where pensions differ quite a bit from ISAs.

Starting with ISAs, there are effectively no rules or restrictions to prevent you from accessing your money once invested. When you take money out of an ISA, you cannot replace it without using up whatever remains of your ISA allowance for that tax year. There might also be planning considerations when it comes to removing money from ISA funds if investment values have fallen.

Pensions come with a number of restrictions in terms of accessing benefits. Firstly, there is an age restriction. At present this is a minimum age of 50. From 6th April 2010 the minimum age at which you can access pension benefits goes up to age 55.

Secondly, there are rules about how much of your pension fund you can access as cash and how much of the fund has to be used to provide an income in retirement. Generally the rules enable to you take up to 25% of the pension fund value as a cash lump sum with the balance reserved for the generation of income.

Some older pension plans offer the possibility of taking more than 25% of the fund as cash, reducing the amount left over to provide an income. This is worth checking, particularly if you are thinking of moving your pension fund to a new provider when your entitlement to greater than 25% cash benefits could be lost on transfer.

Tax treatment of benefits

Capital withdrawals or income generated from an ISA are largely free of tax. With a pension, the cash entitlement is tax-free but the income generated by the remaining pension fund is subject to income tax.

Some people, when they start to take retirement benefits, use their tax-free cash (more accurately described as a pension commencement lump sum) as ‘income’; gradually phasing the taking of pension benefits to produce tax-free ‘income’ for the first few years of their retirement. This can be a particularly helpful strategy if there is no immediate need for a cash lump sum or if you are gradually phasing in your retirement and have other sources of taxable income.

Summary

Pensions and ISAs are two very different tax-wrappers used for retirement planning, but they do share some similarities. It is rarely a case of one being ‘better’ than the other.

Often people planning for their income requirements in retirement will use a combination of pensions and ISAs to create a total retirement fund that has the right balance of tax breaks (but access restrictions) and easy access.

Martin Bamford is a Chartered Financial Planner at Informed Choice and site editor of BrilliantWithMoney.