A Pension or an ISA – What’s Best for my Retirement?

Posted on March 14, 2020

Recent surveys have shown that growing numbers of people putting money aside for retirement are planning to use an ISA to hold the majority – or even all – of their pension pot. Among those over 55 some research has indicated that over a quarter are interested in ISAs, and that rises to over a third among younger savers in certain studies.

Perhaps this growing interest in ISAs is partly responsible for the ‘pensions vs ISAs’ debate that seems to polarise large numbers of financial pundits: many are strongly on one side or the other of the argument. However – as with many things in life – there’s really no need for such binary thinking.

If asked ‘I have an ISA, do I need a pension too?’ or ‘I have a Pension, should I take out an ISA?’ our answer would be this: if you can, we recommend that you have both.

Key questions you should being asking yourself

Whatever form your pension pot takes (and whether it contains cash, or other assets that can be exchanged for cash, or assets that generate income), these should be your considerations:

  • how much can you deposit;
  • how tax-efficient are your deposits;
  • what sort of growth will you see on your deposits;
  • when can you make withdrawals;
  • how much can you withdraw;
  • how tax-efficient are your withdrawals;
  • what happens if you die.

An ISA and a pension are different things, each with its own benefits, limitations or restrictions, and potential issues to consider. In this article we will answer each of the key questions for both.

Note: all figures quoted are for the for 2019/20 tax year.

How much can you deposit?

ISA

Up to £20,000 per year, across all types and all accounts. This is a strict limit: there is no option to pay in any more.

Pension

It’s complicated! The standard annual allowance is the lower of a person’s earned income and £40,000. However, this limit can be reduced for those earning over £110,000, reducing down to £10,000 for those earning £210,000 or more.

The limit here is the amount that can be deposited and full income tax relief claimed. You can pay in more if you wish, but contributions above the threshold will not receive tax relief.

How tax-efficient are your deposits?

ISA

There is no tax relief on deposits here, but all income and growth generated is tax free.

A lifetime ISA, or LISA, is available for the under 40s and does receive some tax relief if spent after aged 60 or before on a first home. For every £100 deposited, the government promised to add £25 when the funds are withdrawn.

Pension

Deposits below the threshold attract tax relief (you can offset contributions against tax that would otherwise be due on your earnings).

This is a major advantage and the higher your tax band the more attractive it becomes. A basic rate taxpayer who deposits £5,000 into a personal pension will receive £1,000 of tax relief from HMRC, meaning the £5,000 investment only cost £4,000. A higher rate taxpayer who contributes £10,000 can receive up to £4000 back, and additional rate tax payers can claim back £4,500.

Let’s put this another way: if you are a basic rate taxpayer and think you can afford to put £4,000 into a pension, you can actually put in £5,000. If you’re a higher rate taxpayer and you think your budget is £6,000, it is actually £10,000.

If you realise these sorts of benefits over the course of a decade or more, the effect that tax relief can have on your pension pot is remarkable.

All income generated by the investments and growth in the value of the assets held in the pension are also free from income and capital gains tax.

Workplace pensions

In addition, if you have a workplace pension then your employer must contribute not less than 3% of your earnings between £6,136 and £50,000. So, if you earn £50,000 and want to contribute £8,000 per annum personally, then that’s an additional £2,000 from tax relief and £1,315.92 contribution from your employer, giving you £11,315.92 in your pension pot.

What sort of growth will you see on your deposits?

Let’s return to the second of the two scenarios immediately above: our employed, basic rate taxpayer on £50,000 a year and able to commit £8,000 to their retirement fund.

If they choose an ISA then, after five years, they would have a ‘baseline’ (setting any interest or other returns aside) balance of £40,000 in the ISA plus £6,579.60 in their workplace pension. If however, all of that money had been invested into a pension, they would be £10,000 better off, with a total ‘baseline’ balance of £56,579.60 (including their workplace pension).

When it comes to growing savings fast in a relatively short space of time, pensions win hands down.

With interest rates as low as they are currently, it is worth mentioning that both Pensions and ISAs can be used as a container for more than just cash and can hold bonds, shares, property, and many other investments. There is a ‘Stocks & Shares ISA’ specifically designed for this purpose.

When can you make withdrawals?

Pensions are normally locked until you’re 55 years old (moving to 57 from 2046), removing any temptation to make a run on the funds before retirement. For balance, note that a Lifetime ISA is as good as locked until you are 60 because of the financial penalties incurred by early withdrawal.

Depending on your financial needs at the time, a prohibition or penalty on withdrawals might feel like more of a curse than a blessing, but it’s hard to view either as a disadvantage if you remember that the purpose of a pension or often a LISA is specifically to provide for retirement.

So, because your ISA allowance and your pension allowance are completely separate, using both to their best advantage will protect your money from taxes, help protect it from you in any ‘moments of weakness’, and give you access to funds that you could fall back on if times get tight.

How much can you withdraw, and how tax efficient are your withdrawals?

We’ve put these two questions together because they are closely connected in the case of pensions.

ISAs

ISAs operate very simply when it comes to taking money out. Any income generated (interest or dividends) is free of tax, as are withdrawals, and there is no Capital Gains Tax (GGT) to pay on any increases in the value of assets held via an ISA.

There is no tax to pay on withdrawals from an ISA, but there might be on a LISA if taken before aged 60 for a purpose other than a house purchase. Care is also needed not trigger a loss of interest from a fixed term Cash ISA by making early withdrawals or reducing the balance below an agreed minimum. then your only concern is reducing your nest egg.

Pensions: the basics

Pensions are not as straightforward when it comes to withdrawals, with a portion taxable and a portion tax-free.

Currently up to 25% of a personal pension can be taken as the ‘Pension Commencement Lump Sum’ or PCLS. It doesn’t need to be taken all at once, which means if the PCLS is taken in a series of small lump sums over the course of several years and the residual funds in the scheme keep growing, you could end up with more than 25% of the value of the scheme when you started accessing your PCLS.

When income tax is eventually due, it is payable at policy holder’s highest marginal rate of tax: there is a tax-free annual allowance of £12,500; 20% is due on income beyond that to £50,000; then 40% due on income to £150,000 and 45% beyond that.

Pension Lifetime Allowance

Each individual also has a Lifetime Pension Allowance, which is the total amount an individual is allowed to accumulate in pensions before punitive tax charges become payable. Saving too much in pensions can therefore be problematic.  Calculating the value of your schemes can be complex depending on the type of pension, whether it is in payment and the current pension legislation.

The current allowance is £1,055,000, so a diligent saver who starts young and receives good investment advice can comfortably reach this level.

Tax on benefits beyond an individual’s Lifetime Pension Allowance is a complex subject, but for rough calculation purposes only it can be understood as 25% on withdrawals taken as income which are then taxed at the relevant income tax rates, or at 55% on benefits taken as lump sum payments and no further tax to pay.

What happens if you die?

ISAs are subject to inheritance tax

ISAs are treated as part of your estate and are subject to Inheritance Tax. Certain benefits pass to your spouse / civil partner automatically (and, indeed, cannot be overridden by a will). For more information see our ISA Q & A article.

Pensions are (usually) not

Pensions are typically Trust-based arrangements which means they do not form part of your estate. On death, the pension trustees (typically the pension provider) have the discretion to pay the pension death benefits to whomever they chose. This is why it is important during your lifetime to ensure your pension provider understands your wishes, so they can make a speedy payment to your beneficiaries of choice. You can nominate a spouse or your children, or literally anyone else – even a charity.

For personal pensions, if death occurs before 75 and the pension is valued at less than the lifetime allowance, the entire value of the plan can be paid out a tax free lump sum. Under new rules, the pension can even be passed on as a ‘dependent’s pension’, from which the inheritor can leave the funds invested, and withdraw the entire amount at will as tax free lumps during their lifetime, then even leave it to their children on their eventual death.

Pensions are not normally subject to Inheritance Tax since they do not form part of the estate.

If you die after 75, the pension can be passed on as a pension, with the inheritor extracting income as required. This income however would be taxed at their highest marginal rate.

INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS, WHICH ARE SUBJECT TO CHANGE. THE TAX BENEFITS RELATING TO ISA INVESTMENTS MAY NOT BE MAINTAINED.

STOCKS & SHARES ISA INVESTMENTS DO NOT INCLUDE THE SAME SECURITY OF CAPITAL THAT IS AFFORDED WITH A CASH ISA. THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.

No guarantee can be given that the information provided is accurate in the present or the future. It is not intended to constitute either a statement of applicable law or financial advice, and responsibility cannot be accepted for any subsequent loss following activity or inactivity by any individual or organisation. Indeed, such information should NOT be acted upon without first receiving appropriate and specific professional advice.