Since their launch in 1999 by the Labour Government, individual savings accounts (ISAs) have been very successful, with millions of Britons ploughing more than £220 billion into their accounts.

As Economic Secretary to the Treasury Kitty Ussher recently claimed, ‘The ISA has been successful in helping more people to save in a tax-efficient way. Over 17 million people now invest in an ISA, more than double the number who ever held a TESSA or PEP.’

The attraction of investing in an ISA is that investors don’t have to pay tax on the interest earned or capital gains made. New rules proposed for April 2008 mean that investors will be able to save more of their hard-earned cash. These changes will allow savers aged 16 and over to earn tax-free interest on up to £3,600 a year in a cash ISA – an increase of £600 – while the allowance for stocks and shares ISAs for over 18s is set to rise to £7,200.

In addition, it is important to realise that, since individual investors are entitled to a new set of ISA allowances each financial year, investments into an ISA portfolio can build up into a substantial sum over time, which can be used in a variety of ways to help you meet specific goals and to plan your financial future.

Security in later years
Just because we are increasingly urged to save more now to fund our retirement at some point in the future, it doesn’t necessarily mean that you should immediately focus all your attention on a formal pension plan.

As managing director of Prudential Retail Life & Pensions Gary Shaughnessy points out, ‘It is important that people look wider than just their pension and review all of the financial options available to them. There are a number of financial products and investments that people can use to enhance their retirement income, such as equity release schemes or, indeed, ISAs.’

Planning for retirement is paramount, according to Shaughnessy, not only so that you can review what financial resources you will have available, but to plan for the income you will need and to choose which financial vehicle would best suit your needs.
The question of whether to invest in a pension or an ISA to fund your retirement income is one with no definitive answer. There are reasons why both are viable options for investors, and they are not mutually exclusive.

In a nutshell, a pensions investor receives tax relief on the contributions they make and the growth of the investment, but pays tax on the income withdrawals. An ISA investor, on the other hand, makes initial contributions out of taxed income, but any growth, and any subsequent income withdrawals, are tax free. This ability to take a tax-free income from your ISA portfolio is a key attraction for many investors planning for their retirement and has the advantage that you can receive income at any time – you don’t have to have reached a certain age or to have officially ‘retired’ to take it – although, the longer you leave your ISA investments to build up, the higher the income you should ultimately be able to take from them.

ISAs versus pensions
The main attraction of investing in a pension, particularly for those who were classed as high-rate taxpayers during their working life, is that your contributions attract tax relief. At the current rate of 22 per cent, every £78 invested is topped up to £100 by the Government for basic-rate taxpayers. For higher-rate taxpayers, a further £18 is added.
An additional benefit of having a pension is the tax-free cash sum of up to 25 per cent that can be withdrawn from the fund. At the moment, this can be done from the age of 50, but this will rise to 55 by 2010.

Table 1, compiled by Hargreaves Lansdown, shows the value of £1,000 invested over a ten-year term in an ISA and in a pension. This data reveals that, even in the instance in which an ISA pays out more (scenario 6), an investor receives 22 per cent tax relief on pension contributions, pays 20 per cent tax on all the benefits from their pension and the financial return from the ISA is less than six per cent.

However, in his final Budget, former Chancellor Gordon Brown made a commitment to lower the standard rate of income tax to 20 per cent in April 2008, with the result that the tax relief will fall to that level. This means that to make your contribution up to £100 you will have to invest £80.

Table 2 shows how this will affect the relative value of pensions compared to ISAs when the changes are brought into effect in April 2008.

The benefits of ISAs
Chris Gilchrist of Everyinvestor.co.uk argues that basic-rate taxpayers would benefit much more from investing in an ISA. ‘Ignoring differences in investment growth or annuity rates, the pension tax incentives are worth just 6.25 per cent for a basic-rate taxpayer,’ he says. ‘A gross investment of £125 in a pension plan will only require a net investment from a basic-rate taxpayer of £100 at the new basic income tax rate of 20 per cent. If 25 per cent of the £125 fund is taken as tax-free cash (£31.25), the remaining £93.75 will all bear income tax at 20 per cent as it is converted into income, leaving a net £75. Added to the tax-free cash, this produces a net £106.25, compared with a net £100 that would be accumulated in an ISA.’

One of the key arguments in favour of ISAs is their flexibility and accessibility. Investments in an ISA don’t attract the attention of the dreaded taxman, which means that you are able to withdraw capital or income whenever you wish. By contrast, there are strict controls over when and how pensions can be paid out. HM Revenue & Customs insists that savings accumulated in a pension should be used primarily for the purpose of providing a retirement income.

‘Rich people with plenty of capital can afford to give up access and flexibility on some of their money,’ says Gilchrist, ‘so it is quite rational for them to invest lump sums in pension plans. But exactly the same logic explains why most standard-rate taxpayers don’t put lump sums into a pension.’

A more flexible friend
The main difference, and arguably the main advantage, that ISAs hold over pensions, is the tax-free income they provide and the inheritability of the capital. On the death of the investor, assets contained in an ISA are incorporated into the investor’s estate. Although these savings will then be subject to inheritance tax (IHT), the investors are free to nominate beneficiaries to receive their savings.

Pensions, in reality, are much more appealing before retirement because upon the death of an investor a private pension has the ability to pay out the full value of savings and the tax relief granted on the contribution, all of which should be free from IHT. Once retirement has been reached, however, investors can’t pass on any more than a ‘token amount’ as a capital sum to inheritors, not including their spouse.

‘The Government position is that pensions are there to provide an income in retirement to the investor or occupational scheme member, to their spouse or civil partner, and to their dependents,’ Tom McPhail, head of pensions research at Hargreaves Lansdown, explains. ‘The trade-off for an investor is that before retirement the potential inheritance from their pension is more generous than an ISA, but after retirement that inheritability is largely exchanged for the security of a life-long income.’

Housing your savings
When it comes to property, an ISA can be used in a variety of ways, from simply using it as a savings vehicle to build up a deposit to linking it to a mortgage as a method of repayment in order to get a better deal.

In the past, endowment policies were used as the main vehicle for mortgage repayments. These were very popular in the 1980s and 90s, when the theory was that the endowment policy would grow to produce a lump sum large enough to repay the loan in full at the end of the pre-agreed period, normally 25 years.

With an endowment policy, your monthly payments are made up of interest on your mortgage and the premium for the endowment. Within the package you also pay for life insurance, which will repay the loan if you die.

Throughout the 1980s, when inflation and interest rates were high and investors could get tax relief on their mortgage payments, the sums worked in favour of these repayment vehicles. However, the tax relief has vanished and both inflation and interest rates have taken a beating, meaning that most endowment policies won’t produce enough money to repay the loan after 25 years.

Using an ISA to help pay off your mortgage works in a similar way. ISA mortgages were developed by lenders as a way of taking advantage of the ISA tax breaks while providing an alternative to endowment-backed mortgages. The idea is that you pay into your ISA every month and at the end of your mortgage term you should have enough money saved to pay off the entire loan.

Understanding the risks
This all sounds simple in theory, but like an endowment policy, relying on an ISA to pay off your mortgage can be risky. While adopting this strategy has the potential to provide you with more money than you require if the stock market performs well, there is also the possibility that it will perform badly, leaving you with insufficient funds to pay off the loan in full.

However, Everyinvestor’s Gilchrist points out that ‘Back in the 1980s, homeowners who had used interest-only mortgages and endowment policies ended up with surpluses of 20 per cent or more after paying off their loans. On the basis of average stock market performance over a 25-year term, today’s borrowers can expect to do as well or better using a low-cost self-select ISA as their savings plan.’

According to Everyinvestor’s calculations, provided borrowers save at least the amount that would be required to repay their loan at their current mortgage rate, the likelihood is that they will achieve a significant surplus at maturity. An average premium of two per cent a year on savings over borrowings would generate a £36,000 surplus on a £100,000 mortgage. A five per cent premium (achieved over 15-year periods ending in the 1990s) would create a surplus of £122,000.

Gilchrist says, ‘Most people remain unaware of the power of compound interest. Making monthly savings into simple stock market plans, such as tracker funds, over long periods like 20 or 25 years is virtually guaranteed to generate wealth on the basis of all the historical data. Putting such a plan alongside an interest-only mortgage is one of the simplest and most effective long-term savings strategies.’

He adds, ‘Most borrowers will not intuitively understand the principle that when interest rates fall, capital repayments on a capital-and-interest mortgage are accelerated and vice versa. This is why it is essential to review the combination of an interest-only mortgage and savings plan at regular intervals.’

Room for manoeuvre
Opting for an ISA mortgage can have its advantages. For example, you can stop paying into your ISA or withdraw your savings whenever you need to if your circumstances change. Similarly, you can pay your mortgage loan off early if your ISA pot reaches the necessary size. And, since ISAs are free from personal taxes – and there is no tax imposed on withdrawals – this is good news for those looking to compound gains over a number of years.

One potential drawback is that the maximum you are able to invest in an ISA in one tax year is £7,000 – rising to £7,200 in April 2008 – which can make it difficult for those who need to borrow a very large sum to opt for an ISA mortgage. However, it is worth remembering that couples each have an individual ISA allowance that can be used in this way.So, for instance, under the 2008/09 ISA rules, both partners can put £7,200 into their ISAs, the equivalent of £600 a month. A total potential family investment of £1,200 a month into ISAs will be sufficient to fund most mortgage loans.

Additional help
If you don’t want to put all of your eggs in one basket, or if you need to borrow an amount that would be impossible to pay off using an ISA mortgage, there is no reason why you can’t opt for a regular repayment mortgage and use the money saved in your ISA to pay off all or part of the loan early.

Making small overpayments on your mortgage each month will reap huge rewards over the longer term. For example, on a £100,000 mortgage taken out on a typical variable rate of 7.5 per cent, overpaying £50 per month will reduce the term of your mortgage by four years and save you over £22,000. Overpaying by £100 per month on the same mortgage will reduce your term by almost seven years and reduce the amount repaid by over £35,000.

Most mortgages now allow borrowers to overpay by a certain amount each year – usually up to ten per cent – without a penalty (see Table 3).

Building a nest egg
With debt in Britain soaring, many young people are put off taking out a student loan to cover the costs of further and higher education. For example, a study carried out by Icesave revealed that over a third of parents are more worried about their children getting into debt compared with their concerns over their child’s prospective A-level grades, and as a result more than half would prefer to contribute to the cost of university tuition.

To add to the concern, in 2006 the Government introduced tuition fees of up to £3,000, which means that those graduating in 2009 will leave with an average debt of £30,000.
Choosing the right university takes time and patience, and the same should be true when considering how to finance further education. Parents must decide how best to help their child through university while ensuring they are able to comfortably manage their own finances.

Support for CTFs
For parents with younger children who are eligible for a Child Trust Fund (CTF) account, saving for education has become slightly easier. The Government offers a starting voucher for the CTF account of £250 and another £250 voucher when the child turns seven. Parents, friends and family members also have the opportunity to contribute to the fund, up to a maximum of £1,200 per year.

However, parents with children who do not qualify for a CTF account, because they were born before September 2002, should be looking for alternative ways to save. One option would be for the parent to use some, or all, of their ISA allowance. The tax benefits of CTFs and ISAs are very similar, in that there are no tax implications for the person who donates the money. Indeed, under recently introduced rules, CTF accounts will automatically convert to ISAs when the child reaches 18.

A key attraction for investing in an ISA now – with a view to providing a lump sum for a child in the future – is that it is held in the parent’s name, stopping any irresponsible spending by the child. And an added benefit to saving in an ISA specifically to contribute towards a child’s university education is that any income derived from the account is not counted when determining grants to aid the costs of university living or when being assessed for any entitlement to tax credits.