What’s better – a Pension or an ISA?
Should I pay into a pension or an ISA? This is a question we are often asked. As a result, we have published this helpful article addressing this exact question. Because pensions and ISAs work differently and have their own set of rules, it can be difficult to choose between them.
What they do have in common is that they are both tax-efficient saving methods.
Your choice depends on your circumstances and what’s most important to you.
There are several factors to consider including tax relief and accessibility.
This simple comparison of the two products should help you get to grips with both options.
What’s covered in this guide?
Here’s a brief overview of the key takeaways in this guide:
- The differences between pensions and ISAs
- A summary of the tax advantages of pensions
- The flexibility benefits of ISA offer
- Contribution limits and tax relief for pensions
- Investment strategies for both options
- Withdrawal rules and age restrictions
- How to make a choice based on your personal goals
A quick overview of each product
A pension is designed specifically to help you save for retirement. One of the key benefits of saving into a pension is that HMRC will contribute too, in the form of quite generous tax relief.
An ISA on the other hand, is essentially a tax-free savings vehicle. There are several types of ISAs. For the sake of this discussion, we will concentrate on the most popular – Cash and Stocks and Shares ISAs.
The differences between Pensions vs ISAs
Pensions and ISAs serve different financial planning purposes. Pensions, primarily for retirement, offer tax relief on contributions but restrict access until at least age 55.
On the other hand, ISAs, offering flexibility, allow for tax-free savings or investments without access restrictions, but without the tax relief on contributions that pensions enjoy.
Paying in
Let’s take a look at the differences in paying into pensions and ISAs.
Paying into a Pension
When you contribute to a pension, you receive an income tax refund on that money. This means that for a basic rate taxpayer, the government effectively adds £25 to every £100 contribution you make. It doesn’t end there. Higher and additional rate taxpayers can claim further tax relief through their self-assessment tax returns. The maximum amount you can save into a pension annually is currently 100% of your salary, up to a maximum of £40,000.
Paying into an ISA
You don’t receive tax-relief when you pay into an ISA, and your investment is made from money you have already been taxed on. This is an important distinction. Your investment is however protected from tax, so you pay no tax on the interest or growth you earn. The maximum amount you can pay into an ISA is £20,000 per tax year and you can make lump sum of monthly contributions up to that limit.
Investment and returns
Now let’s focus on the investment and returns element of each.
Pensions
Pension funds are typically invested in a range of assets, which would include a mix of shares, bonds, property and cash. Designed to provide an income in retirement, pensions are best invested for the long term and would be subject to stock market fluctuations.
ISAs
There are two types of ISAs – Cash ISAs which are tax-free deposit savings accounts and Stocks and Shares ISAs which are invested in a similar way to pensions and therefore better as longer term savings.
Withdrawing money
There are key differences between withdrawing money from pensions and ISAs. Let’s take a look.
Withdrawing money from Pensions
You can only access your pension when you reach 55. This age will increase to 57 in 2028. At that age, you’ll have a few decisions to make including whether to take a tax-free lump sum of 25% of the value of your fund and how to take your income, for example via an annuity.
Withdrawing from an ISA
You can take your money out of your ISA whenever you want, and this will not affect the tax-free status. Just remember that stocks and shares ISA will be subject to market fluctuations.
Conclusion – Pension or an ISA – which is better?
Pensions win when it comes to tax efficiency. This is true both for basic and higher rate taxpayers. ISAs on the other hand win when it comes to flexibility. If you don’t need the money before age 55, consider a pension. If you need flexibility and easy access to your money an ISA may be best.
There are other things to consider, so speak to your financial adviser before making a decision. Either way, using these opportunities together could help you shelter significant amounts of your savings from tax.
Article FAQs
Here are a handful of questions you may have after reading this article.
What are the tax implications of pensions vs ISAs?
Pensions offer tax relief on contributions, meaning you get back some of the tax you paid. Investment growth is tax-free, but withdrawals are taxed as income. ISAs do not provide tax relief on contributions, but investment growth and withdrawals are tax-free, offering more flexibility and simplicity.
How do the flexibility and access differ between them?
Pensions have restricted access, typically from age 55 (rising to 57 from 2028), and offer tax benefits. ISAs allow flexible access at any time without penalties, making them suitable for both short-term and long-term goals. Pensions are designed for retirement, while ISAs provide more immediate financial flexibility.
Which option offers better growth potential for your retirement income?
Pensions typically have better growth potential due to employer contributions and government tax relief on contributions. This compounding effect can significantly grow your wealth and savings over time. ISAs offer tax-free growth but do not benefit from employer contributions or upfront tax relief, making them less potent for long-term retirement growth.
Is it better to invest in a pension or an ISA?
Choosing between a pension or an ISA depends on your goals. Pensions offer tax relief on contributions and are designed for long-term retirement planning but have restricted access until retirement age. ISAs offer more flexibility and tax-free growth but do not provide upfront tax relief. Combining both can be beneficial. Of course, each case is different so this is purely insight and commentary.
Can I withdraw funds from an ISA or pension without penalties?
ISA funds can be withdrawn anytime without penalties, offering great flexibility. Pension funds, however, can typically only be accessed from age 55 (rising to 57 from 2028).
