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Pension or ISA – Which is the Best Choice for Your Financial Future?
New clients frequently ask us whether to save into a pension or an ISA to meet their financial objectives. Although both are tax-efficient savings vehicles, there are significant differences between the two.
You can usually contribute up to £60,000 gross to your pension each year (earnings permitting) and up to £20,000 to an ISA. If affordable, both of these allowances should be made use of.
This article explains how each product works and how they can be used to meet your needs.
Pensions
There are two main types of pension schemes – defined benefit (DB) and defined contribution (DC).
A DB pension (often referred to as a final salary pension) promises to pay a specific amount of income for the member’s life, normally from the scheme’s normal retirement age. The income is calculated based on the member’s years of service and their level of earnings. The income will usually rise in line with either the Retail Price Index (RPI) or Consumer Price Index (CPI) to help protect it from the effects of inflation.
A DC pension, on the other hand, is essentially a savings plan, and its value will be based on how much has been contributed to the pension by you and your employer (if applicable); and how the investment performs over time. Any investments within a DC pension grow free of both income tax and capital gains tax.
You cannot access money in your DC pension until you are age 55 (57 from 2028). The plan value is then typically used to buy a guaranteed income via an annuity or can be placed into a drawdown arrangement whereby it remains invested to provide an income. Or a combination of the two.
Tax relief is available on pension contributions and can significantly boost the performance of your investments, particularly if you are a higher or additional rate taxpayer.
Basic rate taxpayers enjoy tax relief at 20%, but anyone who pays tax at 40% or 45% can claim the extra tax relief on their pension via their tax return. Those earning over £100,000 may even be able to regain their income tax personal allowance, the equivalent of a very attractive 60% tax relief.
Where you have the option to join a workplace pension, it is advisable to do so. Your employer is required to contribute to the plan alongside you. The minimum contribution levels are currently 3% from the employer and 5% from the employee. If done via salary sacrifice, you will not need to claim via your tax return and your employer may even add in the National Insurance saving.
When it comes to accessing your pension benefits, generally, up to 25% of the pot can be taken tax-free, with the remaining 75% taxable as income, whether that be via an annuity or drawdown. Most people expect to pay tax at a lower rate during retirement than during their career.
ISA
ISA stands for ‘Individual Savings Account’. The two main types of ISA are Cash and Stocks & Shares. At Wise Investment, we only arrange with Stocks & Shares ISAs, but we can recommend suitable Cash ISAs as part of your wider planning.
You don’t pay tax on any income or growth from investments, and unlike pensions, you can access the money in an ISA whenever you need it, and all withdrawals are tax-free.
The exception to this is the Lifetime ISA. These are aimed at those wanting to purchase their first home or to save for retirement. They are available for those aged 18 to 40, and you can save up to £4,000 each tax year until you’re 50. This counts towards your annual ISA allowance.
The government will add a 25% bonus to your savings up to a maximum of £1,000 each year. However, you can only withdraw the funds if you’re buying your first home, you’re over the age of 60 or terminally ill. Withdrawals for any other reason are subject to a charge of 25%, as this recovers the government bonus received on your original contribution.
ISAs and Pensions on Death
Defined Contribution Pensions
With the new pension freedoms that were introduced in 2015, you can nominate who your pension fund passes to on your death, dispelling the common myth that your pension fund will disappear should you pass away.
The fund no longer has to be left to a direct descendant and can pass to any beneficiaries you nominate, free of inheritance tax.
Should death occur prior to age 75, the beneficiary will not pay any income tax when they draw on the pot. For death post 75, they would pay tax at their marginal rate of income tax, but they can choose when to draw it and how much, perhaps leaving it until their own retirement.
Each beneficiary can subsequently leave any residual funds to their own beneficiaries on their death, meaning the funds continue down the generations until they are used in full.
It’s important to note that this only applies prior to retirement or if you use a drawdown arrangement. If an annuity has already been purchased, the death benefits will be payable based on whichever options have been selected.
Defined Benefit Pensions
On the death of the member, there will usually be a continuing income for any spouse or civil partner for the remainder of their life, generally at half the rate paid to the member. If there are dependent children, there may also be an income paid until they reach the age of 18.
ISAs
For a married couple or those in a civil partnership, when a spouse dies, the remaining individual can inherit the deceased’s ISA, meaning it retains its tax-free status, which can provide useful tax-free income in retirement. However, on the second death, the funds come out of the ISA wrapper and generally form part of the estate for inheritance tax.
Conclusion
The answer to the initial question depends on your own circumstances and objectives. For many clients in retirement, having pension income, which is taxable but which can be supplemented by tax-free income from an ISA, is the perfect combination.
As professional advisers, we are always here to help if you are having difficulty making a decision.
All information is based on our understanding of current law and practice, which may be subject to change in the future. Past performance is not an indication of future performance. Any investments you make, and any income can go down as well as up – you might not get back the full amount invested.
Wise Investments Limited is authorised and regulated by the Financial Conduct Authority, FCA no. 230553.