2014 has been a year of massive change for pensions and ISAs.
We’ve seen contribution limits raised for ISAs (Individual Savings Accounts) and greater investment flexibility. But pensions have seen even greater changes, with maximum income limits scrapped and taxes on death slashed.
We often get asked whether an ISA or pension is the best way of planning for retirement. So we thought we’d pitch these two options into a head to head battle over nine rounds.
Which one will come out on top?
Round 1: Maximum contributions
ISA You can now pay up to £15,000 each year into an ISA
Pension You can pay in up to 100% of your salary or £40,000, whichever is lower
Winner – Draw For most people the maximum allowable contributions into both options are sufficient for their needs
Round 2: Employer contributions
ISA None. ISAs don’t receive contributions from employers, payments are made by yourself from net pay, after income tax and National Insurance has been deducted
Pension Your employer might already offer a workplace pension, to which you and they will contribute. If they don’t, Automatic Enrolment will soon change this.
Employer contributions can be seen as ‘free’ money; if you don’t join, or opt out of Automatic Enrolment, you will have less money being paid into your pension.
Winner – Pension An overwhelming victory for pensions
Round 3: Tax-relief
ISA None, contributions are made from net income and no tax-relief is received
Pension Any contributions you make to a pension receive tax-relief. Put simply that means for every £80 paid in to a pension by a basic rate taxpayer the taxman will add a further £20.
A higher rate taxpayer can claim a further 20%, making the contribution just £60.
Winner – Pension Another victory for pensions. Most people can’t afford to put enough money away for retirement, tax-relief, as well as employer contributions, are therefore invaluable.
Round 4: Access (part one)
ISA There are no restrictions on when you can access any money held in an ISA
Pension Although George Osborne has introduced ‘Pension Freedom’, you still have to be at least 55 to get access to your pension. For younger workers retiring after 2028, they will have to wait even longer to access their pension
Winner – ISA There’s no doubt ISAs are more flexible when it comes getting access your savings. But, remember you’re saving for retirement; do you really need early access?
Round 5: Access (part two)
ISA Any money you take out of an ISA is tax-free, no matter how much it has grown to.
Pension Currently, once you have reached the age of 55 you can have up to 25% of the pension fund out as a tax-free lump sum. Any additional money you take, in the form of income or lump sum is taxable at your marginal rate of 20%, 40% or 45%.
Winner – Draw Tax-free income from an ISA is certainly attractive, but ISAs don’t qualify for tax-relief in the same way pensions do.
Round 6: Investment flexibility
ISA You can hold funds, Cash as well as individual securities e.g. stocks and shares in your ISA
Pension A pension can hold all of the same assets an ISA, although investing in Cash is trickier, as well as other types of investment, such as commercial property, if you chose to ‘self-invest’ via a SIPP (Self-Invested Personal Pension) or a SSAS (Small Self-Administered Scheme).
Winner – Draw Unless you want to invest in commercial property, or indeed any of the other assets allowed in a SIPP or a SSAS (and most people don’t) the range of investments available in an ISA or ‘mainstream’ pension is sufficient for the needs of most people
Round 7: Maximum fund size
ISA There is no maximum find size your ISA can grow to
Pension Simply put, if your pension pot grows to in excess of £1.25 million, known as the Lifetime Allowance, you will incur punitive tax charges
Winner – ISA Although the £1.25 million limit won’t be a problem for the majority of pension savers!
Round 8: Death benefits
ISA When you die the money held in your ISA forms part of your estate. If this is above the ‘nil rate band’, currently £325,000, then Inheritance Tax (IHT) will be payable at a rate of 40%. This doesn’t apply if you leave your ISA to your spouse, however on their death the capital will be included in their estate and could then be caught by IHT.
Pension From April 2015, if you die before the age of 75 the beneficiaries of your pension will pay no tax whatsoever. If you die after 75, which is of course more likely, your beneficiaries won’t pay IHT, but any money they receive will be added to their existing income and taxed at a rate of 20%, 40% or even 45%.
Winner – Draw Everyone’s circumstances are unique to themselves, Whether an ISA or pension is better depends on when you die and whether or not your assets exceed the ‘nil rate band’. If you die young with significant other assets a pension is probably more beneficial, but if you are older when you die and have assets below the ‘nil rate band’, then an ISA might be a better alternative.
Round 9: Tax in retirement
ISA Any income you take from an ISA is tax-free; the same applies to lump sums withdrawn
Pension You can have 25% of your pension pot out as a lump sum. Any other lump sums or income you take is added to your other income and taxable at a rate of 20%, 40% or 45%. But remember you get a personal allowance, which means that subject to other income, the first £10,000 of pension income could potentially be tax-free
Verdict – Draw Tax-free income from an ISA is attractive, but with the Personal Allowance set at £10,000, and likely to rise in years to come, you would need a large pension pot to produce that level of income
The final verdict – Draw, rematch date to be confirmed!
It’s undoubtedly a close run thing, with ISAs and pensions each winning two rounds.
For most people saving for retirement is a long term commitment, with access to the accumulated capital not needed until well into their 60’s. This means that the enhanced flexibility offered by ISAs might never be used.
Furthermore, for most people who can’t afford to put enough money aside each month for retirement, the tax-relief and potential employer contributions which pensions attract are invaluable.
However, ISAs offer the prospect of tax-free income and unrestricted access.
One possible answer is to fund a pension, taking advantage of the ‘free’ money on offer, to a level which produces enough pension income to ‘fill’ your Personal Allowance or gives you sufficient money to meet your essential expenditure. Then use ISAs to produce a tax-free income to meet discretionary expenditure.
Of course this is just one option, there are many more which could be considered. There really is no simple answer to whether an ISA, pension or a combination of the two is most appropriate. A full independent assessment of your circumstances and objectives would be required to identify the most appropriate way to fund your retirement.
Confused about the best option?
We’re here to help.
Call one of our team of retirement experts on 0115 933 8433 or email info@investmentsense.co.uk
Initial meetings and discussions are free and without obligation.
