As independent financial advisers, we are asked this question a lot and as with many other financial matters our response is normally: “it very much depends on your personal situation” as they both play an important role in financial planning – no hard and fast rules here unfortunately. But if you had to choose: Pension or ISA?
There are many factors that come into play here and it would be impossible to cover it all in a short article. The main differences between Pensions and ISAs relate to: tax on money going in, tax on money being withdrawn, and when you can access the money.
We’ll briefly consider the tax advantages of each using a simple example below with three individuals who would like to save £1,000 in their ISA/pension:
So to get the same amount of money in your pension, it will ‘cost’ you less and the tax benefits are such that it’s very attractive for higher rate tax payers. This is because of something known as ‘tax relief’ from the Government. Such generosity will not last forever and it is widely suspected that we could see this withdrawn, or at the very least significantly reduced, in the near future.
However, money coming out of a pension is taxable under PAYE just like earned income, although you’re normally allowed to take 25% of it tax free.
The only time an ISA leads to a higher withdrawal than a pension is when you become an even higher tax payer in retirement than when you received the tax relief on the contributions (e.g. a basic rate tax payer becoming a higher rate tax payer in retirement). Statistically, the majority of people pay less tax in retirement than when they were working, so this is not normally an issue unless large withdrawals are taken via the new pension freedoms, such as flexi-access drawdown or UFPLS, without prior planning. But this is a discussion for another day and is not within the scope of this article.
Other key issues to consider are:
- Your ultimate goal – what are you saving/investing for?
- Ease of access – ISAs provide full access whereas pensions do not allow access until age 55 minimum.
- Inheritance tax (IHT) – money in a pension is not usually subject to IHT, whereas an ISA is.
- Annual Allowance – £40,000 is the most you can contribute to your pension each tax year.
- Lifetime Allowance – £1.25m (2015/16) is the maximum amount you can have in your pension before being subject to a tax charge.
- Annual ISA limit – £15,240 (2015/16).
The information provided in this article is not intended to offer advice. You should get in touch with us for an initial consultation if you have any financial queries.