Retirement saving: the tax effect

The July 1997 Budget substantially reduced the tax advantages to saving in a private pension by eliminating the dividend tax credit. In spite of this, saving in a pension remains a tax-favoured way to save compared to other 'tax-free' forms of saving such as the new Individual Savings Account. Employer contributions are particularly favoured by the tax system since no National Insurance has to be paid on them.

When it comes to saving for their retirement people have several options. They could put their money in a pension, or they could save in an Individual Savings Account where they could get at their money before retirement if needed. New work at the Institute for Fiscal Studies, funded by the Economic and Social Research Council, has looked at how the tax system might affect where basic rate taxpayers choose to save. A saver with money in an ISA would continue to benefit from the dividend tax credit, but with a pension they would benefit from the tax-free lump sum. The question is which is worth more.

The main findings are:

• Since the dividend tax credit to ISAs is set to last for just five years, the tax system provides a strong incentive for individuals to save in a private pension.
• Should ISAs continue to receive the tax credit for 30 years, then assuming a ten per-cent real rate of return, they would be more tax-favoured than individual contributions to a private pension.
• This assumes that the contributions are made by the individual. Tax relief on employer contributions to a pension is even more generous since these are not subject to employers' or employees' National Insurance Contributions.

Carl Emmerson, one of the authors of the article, said, 'while there may be reasons to encourage individuals to save for their retirement, there is no obvious economic rationale for favouring one type of pension contribution over another. It is also worth remembering that giving a tax advantage to pensions tends to favour those who can afford to tie up their money for a long time'.

Table: The Impact of Different Tax Treatments on the Return to Saving for a Basic Rate Taxpayer

Note to table: These percentages express the additional net fund value after 30 years saving in alternative vehicles, compared to investing in a tax-free savings scheme where no dividend tax credit is paid.

Ends

Notes to editors

1. The article 'A note on the tax treatment of private pensions and Individual Savings Accounts' by Carl Emmerson and Sarah Tanner is published in Fiscal Studies, vol. 21, No.
2. This is available for ñ0 from the Institute for Fiscal Studies, 7 Ridgmount Street, London, WC1E 7AE, 0207 291 4800, @email
3. Current Fiscal Studies articles are now available online to institutional subscribers from Ingenta. They can be purchased online for ñ3 each.
4. This research was funded by the Economic and Social Research Council as part of the research programme of the ESRC Centre for the Microeconomic Analysis of Fiscal Policy.