Pension versus Isa: your future starts here
With the extensive changes to both pensions and Isas introduced in recent years, the two separate tax-advantaged wrappers have become a better complement to each other in many ways.
But with new tax-efficient investment opportunities come new dilemmas. Where should you save first? From which vehicle should you take income? Does the use of one make the other redundant?
One main factor to consider when deciding whether to save into an Isa or a pension is where you are in life. Below, we consider the pros and cons of saving into (and drawing from) an Isa, a pension or both at three different life stages.
EARLY CAREER: AGE 20-45
At first glance pensions seem the obvious choice as they offer hefty initial benefits. Any money paid into a pension enjoys immediate income tax relief, meaning to add £1,000 to your pension fund would cost a basic-rate taxpayer just £800, and a higher-rate taxpayer £600. Plus, once you get to 55 you can take 25% of your pension pot as a tax-free lump sum.
The tax advantages of pensions make them a hugely attractive savings vehicle, but there is one chink in their armour: accessibility.
Unless you take a punt with a dodgy 'pensions unlocking' scheme - or scam, quite possibly - and risk having to pay 55% penalty tax, your pension savings are, in most cases, entirely out of reach until your 55th birthday.
This is why Isa providers have a horse in the race. For younger savers likely to need access to their savings before they reach state pension age, or as an emergency or medium-term fund at any age, an Isa becomes the best bet.
However, a new dilemma arises: every deposit you make into your Isa – because you worry you might need it sooner rather than later – is one that's not benefiting from the tax relief you get on pension contributions.
“The best and most tax efficient approach to long-term savings is a combination of pensions and Isas,” says Patrick Connolly, a certified financial planner at Chase de Vere.
“Pensions provide initial income tax relief, which makes them more attractive to higher earners, while Isas are more flexible as investors can access their money whenever they want it, which can make them more attractive to younger people who usually have financial goals other than saving for retirement.”
If you are saving for a house, for example, then an Isa obviously beats a pension – unless you don’t want to buy your house until you are over 55. Here the Help to Buy Isa is the clear winner as it means the government will give you a 25% top-up to your savings when you buy a home.
Whatever you invest in, be it an Isa or a personal pension, it might help to think about the time of year you make your contributions.
In 2017 a new financial product will hit the market that should appeal to younger savers, the Lifetime Isa (Lisa). This unique Isa will only be available to people aged 18 to 40. In tax terms it sits as a half-way house between pensions and Isas. You will be able to invest up to £4,000 a year and, while you will receive no immediate tax relief on money you pay in you’ll get an annual 25% bonus from the government, plus tax-free growth.
The drawback to the Lsa is accessibility, you will only be able to withdraw your funds after you turn 60, unless you want the money to purchase your first home.
The tax-relief on a Lisa isn’t as good as a pension, but the money is tax-free when you withdraw it, whereas 75% of your pension withdrawals are taxed at your income rate.
The other drawback to a Lisa is that you won’t benefit from employee contributions, as you will with a workplace pension.
“There should be a presumption against taking out a Lisa for those who are not taking full advantage of the matching workplace pension contributions on offer from their employer; for example, a worker who puts £1 into a Lisa would get 25p in top-up from the Government compared with a £1 contribution from an employer who was prepared to ‘match’ employee pension contributions,” says Steve Webb, director of policy at Royal London.
“The Lifetime Isa is essentially a hybrid Isa and pension product combining some pension features like a government bonus in lieu of tax relief and restrictions on how the money can be efficiently accessed and Isa features like the stocks and shares or cash options and tax-free withdrawals.”
The most sensible approach for someone in this age bracket is to build up savings across both Isas and pensions, so you can benefit from the tax-relief and employer contributions of a pension and the flexibility of an Isa.
Pension and Isa basics
- £40,000 annual allowance
- £1 million lifetime allowance
- Marginal-rate tax relief added to your contributions
- Fund grows free of income or capital gains tax
- Pot can be accessed after age 55
- 25% tax-free lump sum can be withdrawn Further withdrawals taxed at marginal rate
- Can be inherited free of tax if you die before 75 (from April 2015)
- £15,240 annual allowance (£20,000 from April 2015)
- Contributions from taxed income
- Savings split any way between cash, and stocks and shares, and peer-to-peer investments
- Fund grows free of income or capital gains tax
- No lifetime limit
- Withdrawals free of tax
- Can be passed on to your spouse
MID-LATER CAREER: AGE 45+-55
In the latter stages of your working life, the decision becomes more straightforward. Generally speaking, a pension should be your first port of call – provided you have some accessible savings.
You're unlikely to retire at 55 and probably won't want to draw from your pension pot while you are still working, but it's not too long to wait before you can access it if you need to – and the tax reliefs outweigh the benefits you get from an Isa investment.
If you are a higher-rate taxpayer, the benefits are particularly appealing, especially if, like most people, you will become a basic-rate taxpayer in retirement.
As an example, say you, as a 40% taxpayer, put £10,000 of taxed income into a pension (costing £6,000 after tax relief) and £6,000 into an Isa. The tax relief you receive on your pension contribution brings your pension pot back up to its gross value, £10,000. Your Isa will stay at £6,000. Let's assume both vehicles are invested in the same funds and their value doubles.
This leaves you with £12,000 in your Isa and £20,000 in your pension. When it comes to withdrawing money, for simplicity's sake, let's say you take it all at once from both places.
Your Isa withdrawal is untaxed, so you can enjoy the full £12,000. Your pension will give you a 25% tax-free lump sum (£5,000), plus - if you have dropped back to the basic- rate tax band – 80% of the remaining £15,000, a total of £17,000 (£5,000 + £12,000).
So when all is said and done, you come out a full £5,000 better off from your pension than your Isa. Even if in the example above, your withdrawal pushed you into the higher-rate tax bracket you would still be £2,000 better off for choosing a pension rather than an Isa.
Basic-rate taxpayers also end up better off in the pension than the Isa. Putting £8,000 into a pension would get you a total of £2,000 tax relief so effectively costs £6,000. If that doubled to £16,000, it could still offer more than a similarly invested Isa which would grow to £12,000. When you drew your pension, you would get the first £4,000 tax-free and pay 20% on the remainder (if within basic rate tax band), to leave you with £13,600, which is still more than your Isa.
The time to consider Isa investments once you are over 45 is if you are approaching your maximum pension allowance.
The lifetime allowance, which includes investment growth, not just contributions, is currently £1 million. Anything above that will probably be taxed at 55%.
If you are in the enviable position of approaching your lifetime allowance limit, you could begin redirecting contributions, not only into your Isa but also into any unused Isa allowance belonging to a spouse or child. Be aware, though, that if you put money into someone else's Isa or Jisa, it belongs to them.
PRE-RETIREMENT AND RETIREMENT: 55 ONWARDS
If you retire before the state pension age of 65, you will have to turn to other sources of income, including your pension savings, which can be accessed from age 55. Keep in mind, though, that your retirement could last maybe another 40 years, so plan carefully how much you can afford to draw from your pot.
You will need to decide which sources you will draw your income from and whether you should start by taking the whole of your 25% tax-free lump sum from your pension. If you opt not to take the tax-free lump sum initially, only three-quarters of any sum then or subsequently withdrawn will be taxed.
Importantly, however, once you are drawing from your pension pot, taking too much at a time could bump you into a higher tax band. There is therefore an argument for drawing income from your Isa at this time: if you use Isa holdings for income, you don't pay tax on withdrawals and moreover you can leave your pension to grow for longer.
Indeed, this is where pensions and Isas really complement each other. Because Isas aren't taxed on withdrawals, if you are in this situation it makes sense to keep pension income under the tax threshold, and then turn to your Isa - maybe drawing capital as well as income to boost your cash flow while avoiding the higher rate tax bracket.
Death and taxes
In addition, pensions are also an effective way to pass your wealth on to your next of kin, so it's sensible to conserve them where possible. Although Isas can be passed on tax-free to your spouse, they will otherwise count as part of your estate, with the balance above the £325,000 threshold (£650,000 for couples) liable for inheritance tax at 40%.
Pension funds, in contrast – whether or not you have drawn from them – can be left to your heirs tax-free if you die before the age of 75. If you die after 75, income from the pension pot will be subject to tax at the beneficiary's marginal rate, and lump sums taxed at 45%.
“This might be an important consideration and for many people could mean that it is more tax efficient to draw income from Isas, and to leave pension investments untouched,” says Mr Connolly.
At the end of all this deliberation, one attractive option seems to be to hold some Isa investments but primarily save into a pension as you get older. You may well take the tax-free lump sum at retirement, but then leave the rest where it is for a while longer and take an income from your Isa, so that the pension can continue to grow and maybe even be passed on to your next of kin when you die. But to do that, you have to build up a good-sized Isa pot as well.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.