Choosing between an ISA or pension isn’t always easy. They’re both tax-efficient savings methods, with good (but different) savings allowances. This makes them both well-suited for major, long-term, financial goals.
However, there are significant differences between the two products, especially in relation to tax and access.
This blog is to explain how pensions and ISAs work. I’ll try to examine the roles both can play in helping you achieve your long-term financial goals.
ISA or Pension?
The first thing to say is that if you have a workplace pension, this should always be the first place you save for your retirement.
Secondly, there are many different types of ISA. You see the definition and explanation of the different types in my Glossary pages. For the purposes of this discussion, I’m going to focus on comparing pensions with Stocks and Shares ISAs. They’re generally the most similar in terms of construction. They’re both subject to the vagaries and risks of investing in the stock market.
Find out more about ISAs at HMRC.
In general, pension savings are vital. You should always have a plan for the money you’ll need when you retire.
Taxes and Allowances for Pensions and ISAs
It’s worth knowing about the tax benefits of investing in an ISA or pension. These can have a major effect on the amount you’ll end up with.
The government allows you to pay in up to 100% of your earnings into pensions, or £40,000 each year, whichever is lower.
Pension providers reclaim basic rate income tax on your contributions. For example, if you put £20,000 into a pension, the government will add a further £5,000 in tax relief and so you’ll have £25,000 invested for your future. And if you pay more than the basic rate, you could reclaim additional tax relief.
As your pension grows there is no capital gains or income tax to pay on the pension fund and because of the tax relief, you’ll have a bigger initial sum invested compared to an ISA.
When you retire, you can take a quarter of your pension pot tax-free. Some pensions let you do this automatically each month and others whenever you need it. After that, you’ll have to pay income tax on the remainder, just as you would on your employment income.
You can save up to £20,000 p.a. in an ISA in 2022/23. It’s worth trying to make the most of this tax-free allowance as well as your pension savings.
You’ll probably have paid income tax on any money you pay into an ISA. However, as it grows, you’ll pay no tax on capital gains and dividends when cashed in.
When Do You Want to Spend the Money?
Access is a key differentiator when choosing an ISA or pension. You cannot access your money in a pension until you’re at least 55 years old. Whereas, for an ISA you may take all or part of your value out whenever you like. This is subject to the specific rules of the product in which you’re invested, of course.
Depending on your specific plans, you may want use ISAs to save for major holidays, saving for a deposit on a house, paying off your mortgage early or anything else.
Which is Best for You, ISA or Pension?
It really does depend on your individual circumstances. If you’re under 55
For retirement savings, a pension is usually best. Firstly, there’s the tax relief on contributions, which enhances the eventual value of your pot over the decades. Also, the fact that your money’s locked in until you’re 55, means you’ll not spend it on anything else.
That said, your pension income will be taxable. Although when you retire, you’ll probably pay a lower rate of tax than you did in your working life.
ISAs, on the other hand, may be better for other major savings goals. Investment allowances are generous, allowing you to build a big tax-free pot of cash and unlike a pension, you can access the money whenever you need it.
Most of us have multiple savings needs, so if you can afford it, why not do both? ISA and pension, rather than ISA or pension.
ISA or Pension: A Quick Comparison
In summary, here’s a quick guide to what was said above.
| Pension | ISA | |
|---|---|---|
| Investment Choice | Contributions can be invested in cash, bonds, shares, or funds, with choice varying according to provider. | Contributions can be invested in cash, bonds, shares, or funds, with choice varying according to provider. |
| Allowance | The lower of 100% of your income or £40,000 p.a. Anything beyond this does not get tax relief. | £20,000 p.a. |
| Access | You cannot access a pension until you’re 55 (rising to 57 in 2028). | Access all or part of your money in an ISA whenever you like (unless it’s a fixed rate cash ISA). |
| Tax | Tax relief on pension contributions. Money grows tax free. When you access your pot, 25% can be taken as a tax-free lump sum the rest is potentially taxable. | Money grows tax free. No tax will be payable when you take money out of your ISA. What you pay in has already been taxed, of course. |
