Quantcast
Menu
Save, make, understand money

Blog

BLOG: Pension or ISA?

Tom Stevenson
Written By:
Tom Stevenson
Posted:
Updated:
10/12/2014

Fidelity’s Tom Stevenson outlines the arguments for each.

We all know that it is important to save for our retirement and to do so in the most tax-efficient way but many savers are confused about whether that means investing in a pension or an ISA. In my view, there is room for both ISAs and pensions in everyone’s long-term savings plans. This is because they have different characteristics which will appeal at different stages of a saver’s life.

ISAs are very flexible savings accounts, offering instant access, although this can be a double-edged sword. The ability to access your funds if you need to may encourage some people to save in the first place but it does open up the risk that savings are dipped into early and not replaced.

Pensions on the other hand tie savings up until at least the age of 55 and then there are restrictions on how they can be accessed. This can be off putting, especially for younger savers, but it does impose a discipline which many people will come to be grateful for in later life.

One of the biggest attractions of ISAs is simplicity. Although they are built out of taxed income, they grow and can be accessed free of tax thereafter. Once you have paid money into an ISA you literally never have to think about tax again – you don’t even have to put your ISAs on your tax return if you complete one of these under self assessment. This can be a real benefit when a retiree plans to use their portfolio to generate an income.

Pensions have the benefit of up front tax relief but they are liable for income tax in payment. The rules around pensions also continue to be tinkered with and there is an ever present possibility that tax relief for higher rate taxpayers may be under threat, which sends out an unfortunate mixed message about the Government’s attitude to retirement saving.

The most important thing about both ISAs and pensions, however, is not the tax wrapper savers choose but the fact that they put money aside regularly, even if it is just a small amount. This is particularly true of ISAs which are a use-it-or-lose-it tax wrapper. The magic of compounding means that saving for longer has an exponential impact on the size of a saver’s final retirement pot.

Because the annual allowance for pension saving is greater than for ISA saving, savers also have the opportunity to save into an ISA when they are younger (and may need to access the funds from time to time) and then to roll their accumulated savings into a pension at a later date (benefiting from the up front tax relief when they do so). This strategy is made easier by the fact that under current legislation pension savers can take advantage of some unused contribution allowances from recent years.

The information below illustrates the different attractions of ISAs and pensions.

ISA

The following tables show the extent to which savings can grow within an ISA over 25 years based on contributing the full allowance each year, compared with savings that don’t benefit from the tax advantages on offer.

 

Basic rate taxpayer over 25 years

Equity Growth Fund  Equity Income Fund  Corporate Bond Fund 
 
Inside an ISA
 £793,447   £793,447  £690,036
 
Outside an ISA
 £718,809   £757,663  £602,074
 
ISA tax benefit
 £74,638   £35,785  £87,962

 

 

 

Higher rate taxpayer
over 25 years

 

 Equity Growth
Fund

Equity Income
Fund 
Corporate Bond Fund 
  Inside an ISA  £793,447  £793,447  £690,036
 Outside an ISA  £677,343  £662,695  £524,143
 ISA tax benefit  £116,104  £130,752  £162,894

 

SIPP

The benefits of saving within a pension are also impressive. If you had the opportunity to turn £12,000 into £20,000, wouldn’t you make the most of it? The following explanation shows just how higher rate tax payers can do this.

  • Invest £16,000 into your SIPP.
  • This is immediately boosted with £4,000 of tax relief, to give a total contribution of £20,000 (£16,000 of your money + £4,000 from the government).
  • You can now claim a refund of £4,000 through your tax return (£16,000 of your money + reclaim £4,000 + £4,000 from the Government).
  • So at the end of the day your £20,000 investment has cost you just £12,000 (£12,000 of your money + £8,000 from the Government).