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ISA or pension? Here are the pros and cons

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AR011047 12/2017

You are allowed to save up to £40,000 a year into a pension and up to £20,000 a year into an ISA. These generous limits mean that pensions and ISAs are the only two savings plans that the vast majority of the population will ever need.  Let’s start with a side-by-side comparison. 

ISAs and pensions compared

ISA

Pension

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 pension fund

No tax relief is given on payments into an ISA

Tax relief is given up to your highest marginal rate of income tax

The accumulated savings fund grows tax efficiently

The accumulated savings fund grows tax efficiently

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

One-quarter of the accumulated pension fund can be withdrawn tax-free.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.   

Ordinarily, your pension fund is exempt when working out the taxable value of your estate for inheritance tax.

No additional tax is payable (unless inheritance tax applies) 

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 at the age of 16 for cash ISAs and 18 for stocks and shares ISAs (also called ‘investment’ ISAs).

The earliest you can usually access a pension is at the age of 55, although earlier access is possible in the case of ill health.

The earliest age you can make payments in is 16 for cash ISAs and 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 the age of 75.

Investment is allowed in cash deposit accounts, 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.

Investment is allowed in cash deposit accounts, 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 £20,000 for 2017/2018. Unused annual allowance cannot be carried forward. There is no lifetime allowance.

The maximum annual allowance, between employer and employee, is £40,000 gross. This is reduced to £10,000 once you access the taxable part of your fund (the three-quarters left after taking tax-free cash). Employee and self-employed contributions cannot exceed 100% of taxable earnings/profits.  Unused annual allowance can be carried forward up to three tax years. There is a lifetime allowance of £1m from April 2016.  

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As you can see from this comparison, pensions and ISAs are actually quite similar. But what tips the balance in favour of one or the other?  

Why pensions? 

  • If you don’t need your savings out before the age of 55 then a pension is likely to be the best choice. That’s because you get tax relief on the payments you make into a pension, but you don’t get tax relief when you make payments into an ISA. 

  • In addition, if you’re employed, your employer must pay into a pension on your behalf (although some small employers are not required to pay in just yet). Employer payments boost your own contributions and you should regard them 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. For example, if you pay 3%, your employer may also pay 3%, and if you pay 5%, your employer may also pay 5%. But, if you pay 6%, your employer may still only pay in 5%. 

  • In general, you should aim to pay into your workplace pension as much as necessary to get the maximum employer contribution. 

  • Opting out of a pension to save in an ISA instead is usually not a good idea, as you lose the benefit of tax relief and an employer’s pension contribution if you are employed. 

  • There are few circumstances where opting-out of a pension is justified, such as affordability or a priority to repay high-interest debts. 

  • In rare circumstances, you may end up paying 40% income tax in retirement but only receive 20% tax relief up-front. In these circumstances, a pension may not be the best choice, particularly if you don’t get an employer contribution.

  • Another rare example of when you should think hard before paying into a pension is where your pension savings are higher than the lifetime allowance (£1m from April 2016). An effective income tax rate of up to 55% applies to any excess savings over this limit, and you don’t qualify for a tax-free lump sum from the excess. Again, whether it is best to opt out will depend on how much your employer contributions are worth. If you have this amount of savings, paying for regulated financial advice is usually the best option to help you make up your mind. 

Why ISAs 

  • ISAs are the most flexible form of tax advantaged saving plan available and can be accessed at any time, including under the age of 55.

  • If the goal you are saving for arises whilst you are below the 55-age limit for accessing pension savings, then an ISA could be a good home for your money. However, as mentioned above, you should avoid opting out of a pension to save in an ISA because you lose the twin benefits of an employer pension payment and tax relief. 

  • Lifetime Individual Savings Accounts (LISAs – see below for more information) could be a useful alternative to pensions, particularly for self-employed people who pay the basic rate of income tax. Self-employed people don’t benefit from an employer’s pension payment, so they won’t lose this if they opt to save in a LISA instead.    

The benefits 

  • ISA and pensions are usually the best ways to save or invest if you remain within your annual ISA or pension savings limits.

  • In most situations, a pension is the best home for your savings or investments if you don’t need the money out before the age of 55.

  • Pay into your pension what you need to get the maximum payment from your employer. If you still have spare cash to save, consider putting the excess into an ISA to give you a more flexible savings portfolio.

  • ISAs are the most flexible tax-efficient home for your savings and investments as you can access them at any time.      

The combination of solutions you use will depend on how much money you have available to save and/or invest. What’s clear is that using your pension and ISA allowances together allows very large amounts of savings and investments to be sheltered tax-free.  
 

 

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