A pension today keeps the revenue at bay

There is an old saying that a bad investment does not become a good one simply because it avoids tax. Similarly, do not be tempted to tie up money long-term in a pension fund just to reduce a tax bill.

But putting income aside for old age is both prudent and highly tax efficient, and needs to be considered seriously as we move towards the end of the tax year. A pension should be thought of as deferred pay. For tax purposes a key question is whether that pay will incur more tax now, or after retirement.

Income tax rates for the higher paid are at historically low levels and there is a strong possibility that they will rise in the future, particularly with the Labour Party apparently poised to win the next election.

Peter Ratcliffe, a senior manager with the accountants Coopers & Lybrand, says well paid employees may be better off not making extra personal contributions - called additional voluntary contributions or AVCs - if they are currently paying tax at the higher 40 per cent rate, and expect still to be paying tax at the higher rate when they retire, by which time the rate may be more punitive. "They would then be better off paying into personal equity plans," says Mr Ratcliffe.

"If they are paying higher rate now, but expect to pay standard rate in retirement then there is a good case for paying into AVCs," he adds. Looked at solely from a tax point of view, Tessas, PEPs and some National Savings products produce equally good returns, while providing more flexibility, argues Coopers & Lybrand.

This view is challenged by Craig Foreman, pensions manager at accountants Deloitte and Touche. "Some people will say let's accept 40 per cent tax today, keep domain on it, and pay the tax," he says. "But that is fallacious logic. You would only get pounds 60 out of pounds 100 to invest, instead of pounds 100. If you compare net money earning net or gross, versus gross money earning gross, the latter will always come out better."

For many middle earners, AVCs can provide a disciplined method of saving for old age, which may be essential if a person's early career involved periods without pensionable employment. The aggregate of payments to an occupational (employer-sponsored) pension plus AVCs is restricted in any one year to a maximum of 15 per cent of pay. AVCs can either be a top- up to an occupational scheme, or as contributions to an independent scheme.

The self-employed and those in non-pensionable employment are allowed to set aside a higher proportion of their pay into personal pensions, and they are also permitted to carry forward for six years any unused contribution relief. Limits for contributions increase with age, starting at 17.5 per cent for the under-35s, rising to a maximum of 40 per cent for those over 61.

Many self-employed people contribute a basic amount each month, topping this up towards the end of their trading year when it becomes clearer how much profit they have made.

A contribution paid now will normally reduce the next tax bill, due on 1 July. It may be possible, though, to obtain immediate relief by formally requesting the Inland Revenue to backdate the contribution into a previous tax year.

If pensions contributions provide a disciplined method of saving, the reverse of the coin is that they are inflexible. While we all need to be adequately protected for our old age, we also need some savings that can be drawn on, without significant penalty, in an emergency. While pensions contributions can be used as security for a loan, it is an expensive and inefficient method of borrowing, and the value of the loan will be less than the amount held in a pensions fund.

"The downside is always that you can't get at the money until you are at least 50, and it may be better to wait until you are 55 or 60," says Mr Foreman. "Clients can borrow against a pension fund. But you have to go through hoops for it, and you won't get hold of all of it."

There is a further important, if uncomfortable, consideration. If you die before you get old then you will gain no benefit from your pension. "If there is a family history of dying in the sixties it seems daft to invest heavily in pensions," says Mr Ratcliffe. "But if the family history is of living to the mid-nineties then a pension's guarantee of paying you for life is important, and it doesn't matter so much about tax rates."

Since 1980, state retirement pensions have ceased to be up-rated in line with average earnings, and increase instead according to the retail price index. This is more significant than it sounds, and represents a major erosion in the value of state pensions. For working people in early or middle adulthood it is sensible to plan for old age on the assumption that the state pension will have little value by the time retirement is reached. The bulk of the pension will therefore have to come from a personal or occupational pension.

Before taking any final decision on whether to increase your pensions contributions you should review your current arrangements by going to an actuary or pensions specialist to project the benefits of existing provision. You can then consider whether they will give you a good standard of living in retirement, and if they do not then you should take steps to increase your contributions, bearing in mind that the younger you do so the more affordable extra payments will be.

Tax gains of raising pension contributions

Full income tax relief on contributions, at 25 per cent rate in current year, or 24 per cent in the 1996/97 year, or at 40 per cent if you are a higher rate taxpayer.

Avoidance of income tax and capital gains tax on income and profits of the underlying funds.

Avoidance of inheritance tax on lump sums.