This post will look at advantages and disadvantages of ISAs and Pensions and then look at the relative merits of each in different situations.

Simplistically:

With an ISA you put your taxed income in an ISA and the returns are not taxed (its actually more complex than this)

With Pensions you put the money in without tax but are taxed on the income in retirement

Things that are the same with an ISA and a Pension:

  • both have tax breaks for contributors
  • you can invest both in almost exactly the same places
  • charges are very similar, although stakeholder pension charges can be very favourable

The Benefits of Pensions

  • there is tax relief on contributions
  • there is not inheritance to pay if you die pre retirement as the funds are outside your estate
  • you cannot withdraw until the age of 55. This forces discipline as a benefit, but lacks flexibility as a disadvantage
  • contributions can increase working/childrens tax credits received giving up to the equivalent of 72% tax relief

Benefits of ISAs

  • ISAs are flexible. You can do with the money what you want when you want to
  • fixed regular withdrawals and income are tax free in retirement
  • at any time the ISA can be paid to beneficiaries, pre or post retirement
  • you can withdraw ISAs and move them into another saving or investment vehicle, such as a pensio

Negatives of pensions

  • you have to purchase a pension annuity which at this time is pre- 75 years of age. There are ASP and USPs but annuities are the Governments favoured method of retirement income from pensions
  • income from pension annuities is subject to tax
  • if you perish after the purchase of your annuity the income may not outlive you (subject to spouse benefit and guarantee period)
  • the earlier you start the pension income the lower the annuity income you will receive
  • the money is tied in so you cant use it for anything else, be it lifestyle or investments.

Disadvantages of ISA

  • It takes great discipline not to take money out
  • On death, the ISA would be subject to Inheritance Tax
  • means testing can include ISAs in the analysis whereas pensions are not included (until they start)

There is no right or wrong answer as to whether a pension or ISA is best as they have different additional benefits in different scenarios. Here are some scenarios to help show different benefits. These are for illustration purposes only and are not advice. You should speak to an IFA about your specific situation.

Scenario 1.
A higher rate tax payer who will be a basic rate tax payer in retirement will benefit from 40% (or higher rate) tax relief on money going into a pension but only pay 22% on what comes out. This makes the pension vehicle a favourable option in this scenario.

The pension wrapper may be ideal for the higher rate taxpayer who will be a basic rate taxpayer in retirement. 40% relief going in and 22% coming out.

Scenario 2.
A self employed person, paying basic rate, with a growing business may need their money available to them to help their business grow. An ISA provides the benefit of being able to dip in to help with business for this person. They would receive basic rate tax relief on pension contributions if they used a pension. As one can invest up to an annual salary in a pension it may be wise to put money in an ISA and then when they reach financial stability and higher rate tax move some or all of the ISA into a pension, gaining higher rate tax relief.

Scenario 3.
An individual with a favourable work pension scheme whereby the employer makes contributions in line with employee contributions would normally be wise to contribute to their pension due to the additional contributions.

It is often the case that a combination of ISA and Pension is a suitable savings hybrid. Speak to a financial adviser to look into your situation and find out what may be best.