Pensions vs ISAs for Retirement

Both pensions and ISAs are extremely tax-efficient investments. Traditionally, pensions are the default option when saving for retirement. But just as retirement has evolved to encompass flexible working and winding down gradually, the options for funding your desired lifestyle have widened.

So if you are thinking about investing for your retirement, would a pension or a Stocks and Shares ISA best meet your requirements?

Contribution Limits

The contribution limit for ISAs is straightforward. Any UK resident over 18, regardless of income or tax position, can invest up to ￡20,000 per year in a Stocks and Shares ISA.

Pensions are more complicated. The main contribution limits are:

• Any UK resident can contribute up to ￡3,600 (gross) per year to a pension, even a child.
• If you have relevant UK earnings, such as a salary or a trading income, you can make higher contributions. These are capped at the level of your earnings.
• If you are employed, your employer should also make contributions to your pension. Business owners can even fund their own pensions through the company.
• Both personal and employer contributions are capped by the annual allowance, which is currently ￡40,000 per year. If you don’t use your full annual allowance, you can carry it forward by up to three tax years, providing you are a member of a pension scheme. But if you want to use your full annual allowance by making personal contributions, you need to have the relevant UK earnings to match.
• Anyone earning over ￡240,000 or who has taken flexible benefits from their pension has a reduced annual allowance.
• While you can, theoretically, exceed the above allowances, your tax relief will be revoked, which defeats the purpose of investing in a pension.

Clearly when it comes to simplicity, ISAs are the frontrunner. But depending on your earnings, you might be able to pay more into a pension.

Tax Relief

When you pay into an ISA, there is no immediate tax relief.

Pensions, on the other hand, offer an instant uplift to your personal contributions. For example, if you want to contribute ￡3,600, you only need to pay in ￡2,880 and HMRC will credit ￡720 directly to your pension. This applies even if you are a non-taxpayer.

Higher and additional rate taxpayers can claim further tax relief (20% and 25% respectively) via self-assessment.

Employer contributions are an allowable expense for corporation tax purposes. Additionally, you don’t pay any tax or National Insurance on pension contributions from your employer.

Both ISAs and pensions grow free of tax. You don’t pay any income tax or capital gains tax on your funds while they remain invested.

Pensions are the clear winner when it comes to tax relief on your contributions.

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Investment Options

Historically, pensions were provided by insurance companies, which offered a limited range of funds. This would usually include the provider’s own funds as well as a few from external managers.

ISAs were typically available from fund managers, and would offer only the provider’s own range of funds.

Today, the distinction is pretty irrelevant. Most platforms now offer both pensions and ISAs, which can normally invest in the same funds from the whole of the market. You can access thousands of investment options with as little as ￡50 per month.

That is not to say that all pension or ISA products offer the full range of funds, but if you are just starting to invest, your fund choice should not be limited by the tax wrapper you select.

Pensions do have a few additional features. Some pension providers will allow you to invest in commercial property or private equity. However, these options are suitable for a tiny minority of investors.

For most people, ISAs and pensions are equally suitable in terms of investment options.

Portability

Both ISAs and pensions can be transferred to other providers without losing tax relief. This can be useful if you have built up multiple funds over the years and would like to consolidate them.

If your funds are invested on a platform, rather than with an insurance company, it might even be possible to transfer your shares directly without selling them first. This avoids time out of the market while the transfer completes.

The portability of your pension or ISA depends on where the money is held and where you want to move it to. In this category, it is a tie between pensions and ISAs.

Accessing Your Money

You can take money out of your ISA without tax or penalty. Some providers even allow you to replace money you have taken out, providing this is done in the same tax year.

Pensions are now more flexible than ever. You can withdraw the full fund as a lump sum if you want to. However, only the first 25% is tax-free. Over and above this, you will pay tax on your pension income at your marginal rate.

Additionally, if your pension is valued at over the Lifetime Allowance (currently ￡1,073,100) when you take benefits, reach age 75, or die before age 75, you will pay tax on the excess at a rate of up to 55%. ISAs do not have any limits on the fund value you can build up.

There are no age limits on taking money out of your ISA. To withdraw money from a pension, you need to be at least 55 (rising to age 57).

When it comes to taking money out of your fund, ISAs are more flexible and the withdrawals are tax-free.

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What Happens When You Die?

You can pass your ISA to a spouse without losing tax benefits. However, if the money goes to anyone else, the ISA status is lost. ISAs also form part of your estate for Inheritance Tax purposes.

Pensions can pass to any beneficiary you choose, either as a lump sum, or a beneficiary drawdown plan.

The benefits are free of tax if you die before age 75. The beneficiary pays their marginal rate of tax if you die after age 75. Pensions can be passed tax-efficiently through the generations.

Pensions offer more advantages when it comes to estate planning.

What About Lifetime ISAs?

You could think of a Lifetime ISA (LISA) as an ISA-Pension hybrid. It works as follows:

• You can set up a LISA between the ages of 18 and 40, and can continue contributing up to age 50.
• You can contribute up to ￡4,000 per year out of your overall ISA allowance.
• The government will top this up by 25%.
• You can only access the money to buy a first home, or after age 60.

If you are thinking of getting on the property ladder but don’t want to neglect your retirement funding, a LISA could allow you to keep your options open.

Should You Invest in a Pension or an ISA?

A pension is the best option if:

• You want to maximise tax-efficiency, particularly if you are a higher rate taxpayer or a business owner.
• You don’t need to access the money until you reach retirement age.
• You want to pass the funds tax-efficiently to the next generation if you die.

On the other hand, and ISA could work better if:

• You prefer simple contributions limits.
• You want to be able to access the money without restrictions or tax.
• You would like to retire before the minimum retirement age.
• You are already making the maximum pension contributions.

Ultimately, both pensions and ISAs have a valuable place in any financial plan. It’s a good idea to incorporate both.

Disclaimer: The information provided in this blog post is for educational purposes only and should not be considered as financial advice. Consult with a qualified financial adviser before making any investment decisions.

The Financial Conduct Authority (FCA) do not regulate Inheritance Tax Planning, Tax and Trusts.

The benefits to the treatment of tax will depend on your individual circumstances and may be subject to change in future.

The value of investments and the income they produce may go down as well as up. You may get back less than you originally invested

Pensions are a long-term investment. You may get back less than you originally put in. Pensions are subject to tax and regulatory change, meaning the tax treatment of pension benefits can and may change in the future.

Figures correct at time of writing.