The age old debate: Pension versus ISA

The end of the tax year is fast approaching, when savers are encouraged to ensure they have made the most of the allowances available to them. And we end up facing that age old question: ‘Pension or ISA’? Andy James, head of retirement planning at Tilney, looks at the benefits of both.

The case for pensions:

“Pensions are the most tax efficient saving route. Savers contributing into a pension receive tax relief at the same rate they pay income tax, meaning that returns are boosted at the outset which will lead to higher returns than an ISA on a like for like basis. Essentially, for higher rate taxpayers, a contribution of £10,000 will only cost £6,000 after tax relief and for those on the additional rate of tax the net cost of a contribution will be £5,500. In addition to this, you can receive tax free cash on up to 25% of the fund available when you are taking benefits. The annual saving limit for the majority of savers is also £40,000 – significantly higher than the ISA limit of £20,000.

“If we look at a person saving £10,000 into an ISA, and placing the equivalent cash amount into a pension, the difference is quite stark. Assuming a 6% annualised rate of return net of costs for both, over 20 years the ISA saver would end up with £18,194 after 10 years and £33,102 after 20. However, a higher rate tax payer subscribing £10,000 into a pension will see it get topped up by basic rate tax to £12,500. They will also receive a £2,500 tax credit. Based on the same timescale and return assumptions, the saver would end up with a higher amount of £22,742 after 10 years and £41,378 after 20 years but for a lower net entry cost of £7,500. Essentially, a higher rate tax payer would end up with an extra £8276 return, for £2,500 less cost and they could of course choose to invest the £2,500 tax saving outside the pension as well, further boosting returns.

“One of the main aspects of a pension that could have been off-putting to savers was the inability to access the money. However, with the introduction of the pension freedoms, savers are able to take income as and when required after the age of 55.

“Saving into a pension can also be beneficial from an estate planning point of view in a way that ISAs are not. Money purchase pensions are outside of the estate and thus a highly efficient method of passing on wealth.

“But while it looks from the above sums that pensions clearly have the edge over ISAs, it is not as straightforward as you may think.

On the other hand…

“An ISA is the most efficient and flexible vehicle. When taking benefits from an ISA it is all tax free, whereas pension income is taxable. Similarly, while pensions have become much more accessible in recent years, they are still not as flexible as ISAs. An ISA will allow you to access your savings at any given point in time, rather than having to wait until you are 55 so they can used for a wide range of goals such as paying off a mortgage, funding the costs of a degree or dream holiday as well as part of a retirement income strategy.

“Another major benefit of an ISA over a pension is that there is no upper limit on the amount that can be accumulated in them, unlike the pension lifetime allowance which restricts how much can be saved into a pension. There have also been various cuts to the amount you can pay into your pension over the years – most notably, the recently introduced tapered allowance for high earners – which is something to bear in mind when planning for the future.

“Finally, an ISA could be beneficial to basic rate tax payers, especially if they utilise the government’s Lifetime ISA.

“The decision between a pension and an ISA will ultimately depend on your individual circumstances and in many case a combination of ISAs and pensions should be used together as part of a financial plan.”