Before we get into which is best, it is worthwhile reminding ourselves of each structure and their differences.
Pension Plans in this context are plans designed to help you save money for your retirement or later life (so excluding a final salary or defined benefit arrangement that some larger employers still operate, which is a very different thing). Although the term ‘retirement’ is still relevant, you do not need to physically stop work to take benefits and we prefer the term ‘Financial Independence Day’ in our overall planning.
ISAs (Individual Savings Account) are a savings vehicle introduced by the Government to encourage people to save. They offer tax advantages as well and whilst they can be used for shorter term objectives, they can also be used as part of your Financial Independence Day planning.
So let’s look at the key points and differences:
Pension Contributions attract income tax relief at your highest marginal rate, so for example 40% for a high rate tax payer. This means that a contribution of £6,000 will mean that £10,000 is actually available to be invested, the difference being funded by HMRC. By contrast, if you invest the same £6,000 into an ISA, there is no tax relief available so only the £6,000 will be invested. So Pensions get you more money invested for the same contribution.
Up to £40,000 Gross can be contributed into a pension each tax year and gain tax relief, so long as you have an equivalent taxable earned income. However this annual limit starts to reduce once your annual taxable income goes above certain thresholds. For someone who isn’t earning, a pension contribution can still be made and attract basic rate tax relief, but it is limited to a gross contribution of £3,600 pa, or £2,808 after tax relief – a very useful savings strategy for non-earners.
Up to £20,000 pa can be contributed into an ISA each tax year and it doesn’t matter what you earn, so for instance with couples where one partner is not earning, they can still contribute £40,000 between them into ISAs each year.
Money invested in a Pension is not subject to capital gains tax on any growth nor any income tax on any interest or dividends received, giving you tax free growth. This is exactly the same for an ISA, and is one of the key reasons why both Pensions and ISAs should be your first port of call when thinking about savings. Both can also invest in a wide range of investments, including Cash and Stocks and Shares.
Benefits from a Pension currently cannot be taken before age 55, so you are locked in until then. An ISA has no such restriction and gives you accessibility at any time. On the face of it, this gives ISAs a significant advantage, but for some people, the discipline of not being able to touch your savings until ‘retirement’ is appealing.
You can take the capital out from both a Pension (after age 55) and an ISA to suit you – you don’t have to take it all at once. However, with a Pension you can only take 25% of the value tax free, with the balance of 75% being subject to income tax, again at your marginal rate. So whilst you will get tax relief going in, you will potentially pay income tax when taking money out. Of course, your tax band when you make contributions may be different from your tax band in retirement and indeed this gives us an opportunity to help plan your income strategy in retirement to try and minimise the tax you pay. On the other hand, proceeds from an ISA are completely tax free. So whilst you don’t get a tax benefit on your contribution, you pay no tax on the way out.
On death, any money still in your Pension Plan will pass down to your beneficiaries without being subject to Inheritance Tax. If you die before age 75, the money will be completely tax free in the hands of your beneficiaries. If you die after age 75, the proceeds will be subject to the income tax rate of your beneficiaries. But again, crucially they can determine when they actually take out that money and in the meantime can inherit your pension under pension succession rules. This gives us significant opportunities for inter-generational planning. ISAs however do form part of your estate on death and will be subject to Inheritance Tax, even though you can now pass down the ISA itself to your beneficiaries.
So which is best?
When we work through the tax advantages alone, what we find is that Pensions offer a slightly more advantageous framework and should give you, after tax, both a slightly better return and better death benefits. However, the flexibility that ISAs offer is very attractive and the ability to take all of the proceeds out without tax can be very useful, particularly when used in conjunction with a Pension. By using a combination of the tax free cash sum of the Pension, the income tax Personal Allowance for the taxed element of the Pension and the tax free proceeds of an ISA, so long as we have been able to help our clients build up enough capital in both vehicles we can often give clients a very healthy annual ‘income’ without becoming a taxpayer at all.
So, whilst pensions probably slightly have the edge, if you can utilise both that is the optimal strategy. A diversified strategy of ‘tax wrappers’ can be as important as diversification of the underlying investments.
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