Pension Vs ISA

Conventional wisdom suggests that saving for retirement should be done within a pension: primarily because contributions attract valuable tax relief. However, contrary to popular belief, pension income is not paid tax-free. When you come to take your pension, only 25% of the fund is returned to you tax free and the remaining 75% will be subject to income tax. This is worth noting when planning your retirement income.

ISAs on the other hand attract no tax relief on the contribution but withdrawals are completely free of income tax and capital gains tax. The other main feature is your funds are accessible at any point of your choosing, and can even be reinstalled if paid back in the same tax year. Pensions are only accessible from age 55, increasing to age 57 in 2028.

*This could be higher or lower depending on your earnings and previous pension contributions in the last three tax years.

Given the flexibility offered by an ISA, is the tax-free income offered a better prospect? In general, the answer will be no, with pensions still coming out ahead for long-term savings.

To illustrate the point, the following table shows an investment of £10,000 into either an ISA or a pension. The initial contribution will attract tax relief at the applicable rate and assumes that the higher rate taxpayer (HRT) and additional rate tax payer (ART) reinvests the additional tax relief claimed back into the fund.  The fund is then invested for 20 years and grows at a rate of 6% per year.  The example also assumes that the tax status of the individual does not change. After twenty years a basic rate tax payer will have a fund of £40,089 from a pension, versus £32,071 in an ISA. Assuming they take 25% tax free cash of £10,022 and the remaining fund is taxed at 20%, they will still be £2,005 better off.  This is a straightforward example but illustrates the point.

The table demonstrates the miracle of compound interest at work - Albert Einstein’s famed ‘eighth wonder of the world’. The growth on the growth and so on and so on, on the enhanced early contribution makes it hard for ISA savers to catch up over the longer-term

The Institute of Fiscal Studies in a 2014 report estimated that six out of every seven higher rate taxpayers in work will be basic rate taxpayers in retirement. With this in mind, the net result for most people would be even more favourable than the table suggests.

Someone retiring on a full new state pension, could expect an income of £8,767 per annum, below the current £12,500 personal allowance, so in the previous example, not all of the taxable pension fund would attract tax at 20%, further improving the net position.

The position is even stronger if an individual is contributing to a pension through their employer.  Most individual contributions made this way will attract a further contribution from the employer.  This would represent the best value in terms of pound saved. 

Where someone is a higher rate tax player in a company scheme and not paying through salary sacrifice, they must make sure they claim their additional tax relief back by writing to HMRC, completing a tax return, or having their tax code adjusted.  People often miss out on tax relief by not taking these basic steps.

Alternative options

Looking at a more sophisticated approach, John starts out as a basic rate tax payer, he invests £10,000 into an ISA on day one, after five years the fund is worth £13,382. John is now a higher rate tax payer, he takes the money free of tax from the ISA and invests into a pension, his fund is now worth £22,303 with the uplift from tax relief. Invested for a further 15 years, assuming a growth rate of 6%, the fund could be worth £53,450.  Considerably more than if he had just put the fund into a pension when he was a basic rate tax payer, or left it within the ISA.

Lifetime ISAs (LISA) add a further layer to the decision-making process. 18-40 year olds can contribute £4,000 per tax year and the government will add £1,000 where the fund is used for either a first property or retirement. As the table below shows, if you are going to use the fund for retirement as opposed to buying a property, a LISA may be the best option for basic rate or higher rate tax payers who are likely to remain so throughout their lifetime.  However, for a higher rate tax payer likely to be moving to basic rate, the pension is the best option.  

For most higher rate tax-payers the right decision is to start with a pension, while basic rate tax payers who are likely to remain so throughout their working lives might want to consider LISAs, though not at the expense of a workplace pension.  If greater flexibility and access are needed for a specific purpose, such as school fees, then an ISA would be appropriate.  There is no one size fits all and you will need to take account of your earnings and plans when deciding what is right for you personally.