What’s better – a Pension or an ISA?
Because pensions and ISAs work differently and have their own set of rules, it can be difficult choosing between the two. What they do have in common is that they are both tax efficient ways of saving.
Your choice would depend on your personal 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.
A brief summary of Pensions and ISAs
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 difference between Pensions & 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
are much simpler. 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.
