For anyone looking to save in a tax efficient environment, the choice between a pension and an ISA has always been quite an easy one. Until recently, pensions were tied up and ISAs were accessible. If you wanted a tax efficient savings vehicle for your retirement, you went for a pension. If you wanted a tax efficient, yet accessible investment, you went for an ISA.
The new pensions reforms introduced in the recent budget has muddied the waters considerably. You can now access your entire pension fund from age 55, so for older clients, the decision is not quite as clear cut as it once was. So, Personal Pension vs ISA. Who is King?
WHEN ISAS BEAT PENSIONS
Imagine you have two investments, represented by a couple of cakes, one chocolate (cash) and the other strawberry (shares). The taxman would usually pop round once a year and annoyingly, take a bite out of each cake. However, each year, to encourage saving, you’re given a tax free wrapper, like cling film, which you can put around your cake. This wrapper (your ISA wrapper) prevents the taxman from taking a bite.
Although there is a limit to the amount you can save in an ISA (£15,000 in 2014/15) and (£15,240 from April 2015), you now get to choose how you split this between stocks & shares and cash ISAs. You even get to choose whether you want to split it – if not, you can use the whole amount for stocks & shares or the whole amount for cash.
If you want to invest in a tax efficient savings vehicle with a choice between cash and stocks and shares, but want access to your money when you need it as opposed to after age 55, then there is no contest. The ISA wins hands down. ISAs are also simpler to understand and administer.
WHEN PENSIONS BEAT ISAS
If having access to your money prior to age 55 isn’t too much of a concern, then pensions have significant advantages over ISAs; especially if you are a higher rate taxpayer.
Let’s assume that £500 a month (from taxed income) was saved over the 15 years from age 50 to 65 and that your investment grew by 5% per year over the period.
*How much would ISAs and pensions produce as a lump sum by retirement age?
By the age of 65, the saver would have amassed the following lumps sums in ISAs or pensions:
Pension (basic-rate taxpayer): £165,515
Pension (higher-rate taxpayer): £220,687
Why the difference? Well, the pension benefits from tax relief on the way in. A £500 contribution is “grossed up” to £625 for a basic-rate taxpayer and to whopping £833 for a 40% taxpayer. Sadly, the pension would be taxed on the way out, apart from 25% of the fund which would be paid out tax-free. The ISA fund would pay no tax whatsoever on withdrawal.
Regardless of how you take your fund, the pension is better than ISA in all cases. The reason for this is principally the fact that only 75% of the pension’s income is taxable and 25% is tax free. The best case scenario is if you were a higher rate taxpayer when contributing, but became a basic rate taxpayer when receiving your income.
So which is better? If you don’t need access before age 55, then Pension wins. No question. However, the ISA is still a fantastic and flexible investment. Me? I’d go for a canny combination of both.
Article by Akwasi Duodu, Sterling & Law Group plc