A good time to compare your options
You’ve probably heard that some significant changes to taxation are coming into effect on 6 April, including changes to the way bank and building society account interest is taxed and new rules on paying tax on dividend income.
Regardless of the new rules, ISAs and pensions remain the two most tax-advantaged ways to save or invest. Let’s start with a side-by-side comparison:
ISAs and pensions compared
|No tax relief is given on payments into an ISA||Tax relief is given up to highest marginal rate of income tax|
|The accumulated savings fund grows tax free||The accumulated savings fund grows tax free|
|No capital gains tax is payable when savings are accessed||No capital gains tax is payable when savings are accessed|
|No income tax is payable when savings are accessed||Ordinarily one quarter of the accumulated savings can be taken tax free. Withdrawals from the remaining three quarters are taxed as income at your highest marginal rate of income tax.|
|An ISA forms part of your estate, unless left to an exempt beneficiary such as a spouse or civil partner. If your estate is more than the inheritance tax nil rate band of £325,000, tax at a rate of 40% could be payable on any excess.||Your pension fund is not normally counted when working out the taxable value of your estate for inheritance tax.|
|No additional tax is payable (unless inheritance tax applies)||Assuming benefits within Lifetime Allowance, on death before age 75, no additional tax is payable. On death after age 75, if paid to an individual, the recipient of your savings fund pays income tax on withdrawals at their highest marginal rate of income tax.|
|The earliest you can access your savings is age 16 for cash ISAs and age 18 for stocks and shares ISAs (also called ‘investment’ ISAs)||The earliest you can usually access a pension is age 55, although earlier access is possible in the case of ill health|
|The earliest age you can make payments is age 16 for cash ISAs and age 18 for stocks and shares ISAs (also called ‘investment’ ISAs). There is no maximum age limit. Children under the age of 18 can have a Junior ISA opened on their behalf from birth.||Payments can be made from birth to age 75.|
|Investment is allowed in cash bank account, shares, government and corporate bonds. In addition to direct investments, a wide range of funds are available which invest in cash, shares and bonds and other investments such as property. Direct investment in residential property isn’t allowed.||Investment is allowed in cash bank account, shares, government and corporate bonds. In addition to direct investments, a wide range of funds are available that invest in cash, shares and bonds and other investments such as property. Direct investment in residential property isn’t allowed.|
|The maximum annual allowance is £15,240 for 2015/16. Unused annual allowance cannot be carried forward. There is no lifetime allowance.||The maximum annual allowance, between employer and employee, is £40,000 gross. For defined contribution (money purchase) pensions plans, this is reduced to £10,000 once you flexibly access the taxable (the three quarters left after taking tax-free cash) part of your fund. Employee and self-employed contributions cannot exceed 100% of taxable earnings. Unused annual allowance can be carried forward up to three tax years. There is a lifetime allowance of £1m from April 2016.|
|Employers can’t make payments on your behalf||If you are employed and earn enough, your employer must enrol you into a pension and make minimum payments into your savings fund|
As you can see from this comparison, pensions and ISAs are actually quite similar. But what might tip the balance in favour of one or the other?
If you don’t need access to your money before age 55 then the advantage of a pension is that you get tax relief on the payments you make into it, but you don’t get tax relief when you make payments into an ISA.
In addition, if you are employed, your employer must pay into a pension on your behalf (although this requirement won’t apply to some small employers until April 2017). Employer payments boost your own contributions and could in a sense be regarded as ‘free money’.
Many employer pensions are tiered, meaning you get a higher employer payment the more you pay – up to a cut-off limit.
In general, you should aim to pay into your workplace pension as much as necessary to get the maximum employer contribution.
The option to opt out
Since automatic enrolment started in 2012, the opt-out rate has been low – less than 15% of those enrolled. However, the opt-out rate amongst older people is much higher. One Department for Work and Pensions study put the figure for over-50s at 23%.
Anyone thinking of opting out of a pension to save in an ISA instead should consider the fact that they would lose the benefit of tax relief – as well as any employer’s pension contribution if they’re employed.
In rare circumstances, it’s possible to end up paying 40% income tax in retirement, while only receiving 20% tax relief up-front. In these circumstances, a pension may not be the best choice – particularly if there’s no employer contribution.
Another rare example of when someone might need to think carefully before paying into a pension would be the happy scenario where pension savings are higher than the lifetime allowance (£1m from April 2016). An additional effective income tax rate of 15% applies to any excess savings over this limit, and the rules don’t allow a tax-free lump sum to be taken from the excess. Again, whether it’s best to opt out would depend on the value of any employer contributions. At this level of savings, paying for regulated financial advice is the best option to help you make up your mind.
Comparing ISAs and pensions for a 50-year-old who wants their money back out at age 55
Let’s assume that someone aged 50 wants to put aside £1,000 from their own money and wants to withdraw the full plan value at age 55. They are a basic rate taxpayer. To keep it simple, we will assume that the money doesn’t grow in value (in practice, ISAs and pensions invested in the same assets should grow at the same rate, because both grow tax efficiently).
If they put the money in a pension, the government will add tax relief of 20% (of the gross amount). In this case, the tax relief is £250, which is 20% of the total gross amount of £1,250 (£1,000 net, plus £250 tax relief).
At age 55, they can take a quarter of the £1,250 (£312.50) tax free, with the remaining £937.50 taxed at, say, 20%. This means they receive £312.50 from the tax-free part and £750 from the taxed part, giving a total of £1062.50.
If they put the money in an ISA, they would get £1,000 back at age 55.
This short example shows the benefit of pensions tax relief for older investors. This works even better if the rate of income tax you pay in retirement is less than the rate of tax relief you receive on payments into your pension.
It's important to note that there are a number of other factors that may influence your decision as to what savings vehicle is right for you. If you're in any doubt, please seek advice.
ISAs are the most flexible form of tax advantaged saving plan available. Although ISAs can be accessed at any time, including under the age of 55, stocks and shares ISAs are usually taken out with the intention of keeping the investment in place for the medium to long-term (5 years plus).
If you’re saving for a particular goal which arises while you are below the age-55 limit for pensions, then an ISA may be the best home for your money.
If you’ve read our article on changes to the way bank and building society account interest is taxed, you’ll recognise that it’s possible to achieve ISA-like tax treatment for cash savings and for shares-based investments up to certain limits. This may mean that you want to use your ISA allowance to shelter investments that aren’t covered by other allowances. These might include shares and funds that target growth where that growth might ultimately end up being taxed under the capital gains tax rules (these would apply if the gain is more than the capital gains tax exempt amount).
It could also be said that ISAs are less hassle than using either the new £1,000/£500 limit for bank deposit interest and the £5,000 limit for share dividends. This is because once your money is in an ISA, you don’t have to monitor it to see whether the income is exceeding any particular limit.
- ISA and pensions may be an appropriate choice to save or invest if you can do so well within your annual ISA or pension allowance. However, you may gain a little advantage by holding cash in ordinary bank deposits – this is because they currently offer slightly higher interest rates than cash ISAs.
- Make sure you shop around for the best interest rate for your cash savings over the period you’re prepared to lock your cash savings away.
- Consider holding cash outside of an ISA using the new £1,000/£500 tax-free interest limits, particularly if you want to keep your ISA allowance free for other types of investment. For example, using your ISA allowance for stocks and shares.
- You could use the new £5,000 Dividend Allowance to receive share and fund dividends tax-free for investments outside of an ISA and a pension. This allowance may be particularly useful when holding shares or share-based funds that aim to pay high dividends.
- Consider a pension for your savings or investments if you don't need the money out before age 55.
- ISAs are the most flexible tax-efficient home for your savings and investments, as you can access them at any time – although stocks and shares ISAs are usually held for the medium to long-term.
The combination of solutions you use will depend on how much money you have available to save and/or invest. What it is clear is that using all these allowances together allows very large amounts of savings and investments to be sheltered tax efficiently.
This article is not intended to give advice or a personal recommendation. If you need a personalised recommendation based on your personal circumstances, you should seek financial advice. You can find a financial adviser in your area at www.unbiased.co.uk