Pensions versus ISAs: An in-depth comparison to help savers get the most out of their tax-free options

Pensions make up 42% of wealth in Britain, according to the latest research by the Office for National Statistics – an even greater proportion than property, minus mortgage debt, which accounts for 36%. Financial wealth, meanwhile, in the form of savings or investments, makes up 13%. [1]

Total pension wealth has nearly doubled since the financial crisis, and while some of this is due to the investment growth of pension pots, there is no doubt that nationally contributing into a personal pension is on the up. In 2012 employees began to be automatically enrolled into workplace pensions, since when the proportion of private sector workers with a pension has grown from 42% to 86%.

With just over a month left to the end of the tax year, those with a lump sum languishing in their bank account will be looking at where to put it. And a common quandary is which long-term tax-efficient savings vehicles to use - a personal pension or an investment ISA?

That’s assuming the warning light isn’t blinking on either annual allowance. That stands at £20,000 for ISAs, and for most people the gross annual pensions allowance is £40,000, which includes tax relief. The answer will depend on the saver’s financial situation, their objectives and their whereabouts on the savings journey – but some of the hard numbers are in pensions’ favour.

Tax benefits

The tax benefits of contributing to personal pensions are substantial and increase with earnings. Tax relief means that if a basic-rate taxpayer contributes £800, the Government pays in an extra £200, and that is a boost of 25% to their pot.

Jason Hollands, managing director at investment platform Bestinvest says: ‘For higher-rate taxpayers, pension saving carries even greater benefits. Alongside the basic rate top-up, they can obtain a reduction on their tax bill for the year so that total tax relief is at their marginal rate of 40% or 45%.

‘For someone paying tax at the 40p band, this obtains them a £10,000 gross pension investment for a net cost of £6,000 after tax relief, and for a 45p taxpayer the net cost is £5,500.’

That would seem to relegate investing ISAs to a poor second, as we pay into those from net income and on the main ISA allowance there is no top-up from the state. But they have the benefit that no tax is payable on either income or capital gains when the ISA is accessed, and that access is more flexible.

Tax costs

‘There is no tax payable on the growth of a pension fund, although that growth could take you over the Lifetime Allowance (currently £1.073 million), above which tax charges will apply when you take pension benefits,’ says Hollands. ‘But there will probably be some tax to pay on income taken from the pot. There are two reasons, however, why this tends to be outweighed by the pension’s benefits.’

One, pension savers can access 25% of their pension pot tax free from age 55, and through some careful financial planning steps beyond that can be taken to draw down from their scheme in as tax-efficient way as possible.

Two, because the boost to pensions comes at the start of the savings journey, the effects of compound returns are greater.

Pension pump-priming

To illustrate this, imagine a £10,000 investment into a fund that grows at five per cent a year (after fees) over 20 years. In the case of an ISA this would end up at £27,126. If the same amount were contributed through a pension it would be topped up by £2,500 to £12,500. This higher initial investment would result in a sum of £33,908 over the same period.

Hollands adds: ‘Moreover, if the investor was a higher rate taxpayer, they would also have received £2,500 off their tax bill to do with as they please. If they used this to invest an ISA alongside their pension, and assuming 5% again, the ISA could grow to £6,781 after 20 years, extending the pension’s “lead” even further.’

On the downside, as the pension pot grows ever bigger, more of it will likely be subject to tax as it is accessed - but as noted steps can be taken to moderate that.

Accessibility

Where ISA saving does win out, hands down is flexibility.

‘Pension pots cannot be accessed until age 55 (set to rise to 57), and this is why for most people pensions are best reserved for their intended purpose – a retirement fund,’ says Hollands. ‘Meanwhile, ISAs can be accessed any time, with no tax on withdrawals, so are more suited to medium-term goals like paying off mortage, education fees, wedding costs, a dream holiday or a rainy-day fund.’

Conversely however, for savers over 50 the restrictions on pension access become less meaningful, with the option of a significant tax-free lump-sum on the horizon.

Treatment on death

In weighing up pensions or ISAs, a further consideration might be how these two schemes could be treated on death. Everyone has an allowance at which wealth can be passed on after they die without being subject to inheritance tax (IHT), but it has been frozen at £325,000 per person for a decade now – and will remain so until at least April 2026 - and so has shrunk considerably in real terms as a result of inflation.

Hollands says: ‘Rising property prices and strong investment returns over this period mean that more and more people are at risk of falling into the trap of Inheritance Tax. In the case of ISAs, when a person dies their surviving spouse or civil partner is provided with a one-off additional ISA allowance equivalent to the value of their deceased partner’s ISAs, so they can chose to reinvest in their own name and preserve the value of the ISA tax allowances.’

However, ISAs cannot be passed-on to future generations or to other beneficiaries, just the surviving spouse. ISAs will therefore form part of an estate for inheritance tax purposes on the death of the surviving partner unless the ISA is invested in riskier AIM-listed companies that might qualify for an allowance known as Business Relief once the shares have been held for two years.

‘Shares deemed eligible for Business Relief escape being included as part of an estate for inheritance tax purposes, but this assessment takes place at the point of probate,’ says Hollands. ‘In contrast, pensions are now a very attractive route for passing wealth on, as any remaining assets in them are not currently subject to inheritance tax.’

He adds: ‘These can be left to whomever you chose. Depending on how old you are when you die, your beneficiaries may still have to pay Income Tax on the money they withdraw from an inherited pension. If you die before age 75 the beneficiaries will have no tax liability. If you die after your 75th birthday, your beneficiaries may need to pay Income Tax at their own income tax rate but only when they make withdrawals from the inherited pension (which they could choose to leave untouched and pass on themselves).’

It’s not either / or...

Age obviously plays an important part in these calculations.

Younger savers have a huge advantage when it comes to pension saving: the power of compounded returns means early contributions will turbo-charge the pot over time. This can obviate the need to pay greater amounts later into one’s career.

There are many calls on young workers’ salaries, such as saving for a deposit on a home, and these priorities normally point towards a flexible savings option like an ISA or Lifetime ISA (LISA). But a widespread regret among older workers is not having started contributing to a private pension earlier.
Hollands concludes: ‘ISAs and Pensions have become firmly established as the two key pillars of longer-term, tax efficient savings in the UK. Both are extremely valuable tools in building a solid financial plan and helping people achieve their goals and in most cases people able to set aside some cash should consider a combination of ISAs and Pensions, rather than regard them as an either / or choice.’

NOTES FOR EDITORS

[1] Office for National Statistics, 7 January 2022: Household total wealth in Great Britain: April 2018 to March 2020