When looking to invest for later life, both ISAs (Individual Savings Account) and pensions potential growth within a tax efficient environment and should be considered. But which is better?
The answer to this question will depend on you (your needs, financial goals and your appetite for risk), but as these products work in slightly different ways, we’ll cover a few of the advantages to these products in this article.
Both pensions and ISAs grow in a tax-free environment. The difference between these two products occurs when putting funds in and taking them out – and when you can do so. Pension savings are locked away until you are at least 55, but a stocks and shares ISA will allow you to access your money whenever you want to.
How these products are taxed
Pensions will give you tax relief on money going in, but when it comes to drawing on your pension tax will be payable at your marginal rate. ISA investments don’t allow for tax relief on the money being invested, but they do give you total tax exemption on any gains made within the ISA. So with an ISA when you come to withdraw funds from an ISA you will not pay a penny of tax.
There are two main advantages to a pension. Firstly, assuming 25% tax-free cash is taken, 75% of the pension proceeds are taxed. The second advantage is the tax relief gained on a pension investment will often be higher than the tax paid on the withdrawal – as tax relief is added at the investor’s highest marginal rate of income tax. Their pension income is likely to fall within their personal allowance meaning that while basic rate tax is claimed on the contribution, no tax is paid on that part of the benefit. (It is also likely that higher rate working taxpayers will then become to basic rate tax payers in retirement.)
Tax comparison
| Pension | ISA | |
|---|---|---|
| Funds in | Income tax relief on contributions at the highest marginal rate | No tax relief on contributions |
| Investment returns | No tax paid on income and gains | No tax paid on income and gains |
| Funds out | 25% of fund paid as tax free cash. Remaining fund subject to income tax at highest marginal rate | Not subject to income tax or Capital Gains Tax |
| Death benefits pre-75 | Paid as a lump sum or drawdown to nominated beneficiary free of all tax. Does not normally form part of estate. | Forms part of estate and subject to IHT if estate exceed nil rate band and not left to exempt beneficiary. Spouse/civil partner can inherit additional ISA allowance based on value of deceased's ISA funds |
| Death benefits post-75 | Taxed at beneficiary's marginal rate Does not normally form part of estate | Forms part of estate and subject to IHT if estate exceeds nil rate band and not left to exempt beneficiary Spouse/civil partner can inherit additional ISA allowance based on value of deceased's ISA funds |
What your savings could look like
The maximum you can contribute to your pension each year (and receive tax relief) is £40,000. For an ISA, the overall annual limit is currently £20,000. Let’s compare these two products, assuming the client is a basic rate taxpayer.
| Pension | ISA | |
|---|---|---|
| Funds in | £100.00 | £100.00 |
| Further contributions | 20% tax relief | No tax relief |
| Investment | £120.00 | £100.00 |
| 25% of fund paid as tax free cash. Remaining fund subject to income tax at highest marginal rate | Not subject to income tax or Capital Gains Tax |
Inheritance
Pensions can have advantages over ISAs in the event of death. ISA funds will always form part of the estate for inheritance tax, however with a pension the benefits paid on death do not normally form part of the investor’s estate. With the new pension flexibility, this means it is also possible to pass the funds down through the generations while keeping the funds invested in a tax efficient beneficiary’s drawdown.
There is a place for both ISAs and pensions when considering the tax efficient methods of saving. For the time being pensions can still offer significant tax advantages over ISA. There are other products which a financial adviser may consider when advising a client, various types of pensions and ISA schemes. Talk to your financial adviser for more information.
This information is based on our understanding of current tax law and pension rules. The value of an investment and income from it can go down as well as up. The levels, bases and reliefs from taxation are subject to the individual circumstances of the investor, and may be subject to change. You should not view any of the information contained within this article as advice. If you’d like to discuss your retirement plan, we’d recommend contacting your independent financial adviser.
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