Pension or ISA … which is better?

Our comparison of the two gives you a clear picture.

An Individual Savings Account (ISA) allows you to save up to £20,000 each year without paying tax on interest, dividends or capital gains. You can withdraw the money at any time tax free.

You can pay up to £40,000 each year into a pension fund depending on your circumstances and other factors.* The invested money grows free of all taxes, generous income tax reliefs are available on contributions and the fund is free of inheritance tax on your death. You can’t access the money until you are 55, however, apart from in very rare situations.

Drawing money from a pension is subject to complex rules, and income tax is potentially payable on the bulk of it.

*Always seek advice before making any pension payment, as penalties for overpayment can be very high.

A Lifetime Allowance charge is applied to pension funds in excess of £1,073,100, and additional premiums may invalidate any protections you have in place against this.

TAX RELIEF

You are entitled to basic rate tax relief at 20% from the government when you make contributions to your pension. For example, if you wanted a total of £1,000 invested in your pension, you only pay £800. The government adds £200 (20% of the gross amount), which effectively tops up your payment by 25%.

Tax relief is linked to the highest band of income tax you pay, and higher rate or additional rate taxpayers can claim a further 20% or 25% respectively through their self-assessment tax returns or tax code.

ISA contributions don’t qualify for any tax relief but income generated doesn’t affect your personal savings tax allowances.

INVESTMENTS AND RETURNS

Both pensions and ISAs allow you to pay cash into them and invest in a vast range of funds – but not all. There are strict rules and restrictions, and your provider will ensure that your choices comply.

Caution: Your capital is at risk if it’s not in cash or on deposit, and past performance of any investment fund is not a guide to future performance.

WITHDRAWING MONEY

Pensions

From age 55, you can start drawing money. 25p in every £1 can be taken income tax-free, and the remaining 75p will be subject to your marginal tax rate: 0% if when added to your total income it doesn’t exceed your personal allowance; 20% if it falls within the basic rate band; 40% for higher rate and so on.

You can use your fund to buy an annuity – a guaranteed income for life or for a fixed term. This eliminates investment risk but may provide poor value if you die in the early years, with little or no money returned to your family. Ultra-low interest rates and Gilt yields mean low starting incomes, particularly for younger annuity holders, and there is no option for tax planning once the income has started.

If you can tolerate investment risk and income uncertainty, you can leave your pension fund invested and take money out when needed on a ’drawdown’ basis. This option can be tax-efficient as it allows you to start and stop drawing as required. Be careful though. Your pension is designed to last a lifetime and drawing too much too soon can leave you short in older age.

ISAs

You can withdraw money from your ISA whenever you want, though some providers may apply penalties. You can take just the income generated and maintain the capital or shares. Capital can be withdrawn too but this means that the income-generating capacity is lost.

You can also repay withdrawals without affecting your annual contribution allowance if done within the same tax year and it’s a flexible ISA.

INHERITANCE TAX

Pensions

Money left in a defined contribution pension when you die can be inherited by anyone you choose free of inheritance tax (IHT). On death before age 75, your beneficiaries can take the money free of any tax. After 75, they will pay tax at their marginal income tax rate.

If the pension scheme allows, it can be inherited as a pension and continue to benefit from tax-free growth. This is ideal for your widow or widower. They can draw a tax-efficient income and the pension remains outside of their estate for IHT purposes. On their death, it can be passed to the next generation IHT-free.

Ask us to review your schemes to make sure that they are ‘inheritable’ and have the correct nomination of beneficiaries for maximum flexibility and tax savings.

ISAs

Money in your ISAs is part of your estate, and your beneficiaries may have to pay IHT. The tax is 40% and is charged on estates worth over £325,000 (or £500,000 if the Residence Nil Rate Band applies). IHT doesn’t apply if you’re passing your money on to your spouse or civil partner.

Your spouse or civil partner can also claim an Additional Permitted Subscription allowance equal to the value of your ISA at the date of your death and with the tax benefits retained.

OPTIMISING YOUR SCHEMES

Your pensions and ISAs may not be invested as well as they could be. Consolidating them into one pension and one ISA, for example, can make administration easier and allow a coherent investment strategy. Costs, penalties and lost pension benefits also need to be considered.

We are happy to review any of your existing schemes and provide a full cost/benefit report and recommendations without charge or obligation.

Please note: This article is for information purposes only and should not be construed as advice. No investment decisions should be made without first getting advice.