Should you pay into a pension or an ISA?

It seems inherent in the British psyche to debate – and dare I say argue – about what is best, with typical examples being red sauce or brown sauce (I am definitely red sauce), EastEnders or Coronation Street, PlayStation or Xbox… and even Hollywood got involved with Batman versus Superman, although the less said about that the better. Of course, who can forget Brexit or remain! And this appetite for debate certainly spreads into financial services, where the debate of instantly accessible savings (ISAs) versus pension funding has raged.  

The tax-efficiency of pensions is hard to beat…

In my opinion, there is no savings vehicle currently available to UK savers that is as tax-efficient as a pension. But, in spite of the clearly advantageous tax incentives, pension contributions have often found themselves down the pecking order in terms of value and importance, even for some of the most knowledgeable.

… but they were restrictive until pension freedoms legislation

In the past, despite the tax incentives offered, it was often difficult to substantiate pension planning with its restricted access, when there were other, more immediate requirements. After waiting until their 55^th birthday, an individual could then only access part of their pension each year. This was not very appealing. But that changed with the introduction of pension freedoms legislation in 2015: savers can now access their pension funds, without restriction, from the age of 55 onwards. They can also leave their pension funds to anyone of their choosing on death.

Pensions V ISAs: it’s rarely binary

Let’s be clear: I love pensions, but a sound financial plan rarely involves a binary choice of either/or. So, while I would categorically not mix red and brown sauce, in my opinion a saver should always consider multiple savings vehicles to provide greater flexibility. But in the spirit of debate, why should you consider a pension over an ISA?

The case for pensions over ISAs

In a bid to fund the retirement savings gap, the Government introduced workplace pension schemes, and now most of the UK working population are active members of their employer pension schemes. Based on current contribution levels, most members of these schemes will be pitching in a minimum of 5% of their qualifying earnings, with their employer contributing at least 3%. If we look, for example, at someone earning £30,000 per annum, this will mean that the employee will be contributing £1,188 (gross) with their employer contributing £712.80.

Typically, the employee will receive basic-rate tax relief on the contributions they make. In this case, following the previous example, they may only need to contribute £950.40, with tax relief of £237.60 topping up the payment.

To take stock: that’s a total pension contribution of £1,900.80 (gross) being made each year, and the saver is only £950.40 out of pocket. Not a bad return – some pension schemes will even provide more.

Unfortunately, there is no requirement for your employer to contribute into your ISA and any contributions made into ISAs don’t receive tax-relief. So, if someone decided to opt out of their pension scheme in favour of an ISA (and saved an equivalent amount), only £950.40 would go into the ISA. This will clearly have a significant impact on their long-term savings.

Using this example, the following graph compares the future values of the employee’s projected pension fund versus potential ISA savings.

Example for illustration purposes only

Are you missing these pension benefits?

Pension savings can also potentially be very effective for those who might be impacted by the Child Benefit High Income Tax charge or who earn between £100,000 and £125,000 and lose their Personal Allowance. Personal pension contributions have the effect of reducing an individual’s income for the purpose of calculating both the Child Benefit Tax charge and the loss of the personal allowance.

The impact of pension contributions on Child Benefit

Anyone in receipt of Child Benefit earning more than £50,000 will face a tax charge, effectively repaying a portion of the benefit received. If earnings exceed £60,000, all of the Child Benefit will have to be repaid. So, someone earning £52,000 would have to repay 20% of any Child Benefit they receive via self-assessment. Therefore, if this individual contributed £2,000 (gross) into a pension, they would be able to retain their full Child Benefit payment with no tax charge resulting.

The value of a pension contribution if you earn £100,000-£125,000

In the current tax year, anyone with earnings between £100,000 and £125,000, currently suffers a marginal rate of Income Tax of 60% as they lose part of their Personal Allowance (tax-free income). Therefore, someone earning £110,000 would be able to retain their full Personal Allowance by contributing £10,000 (gross) into a pension, and the effective cost would only be £4,000, representing 60% tax relief.

Unfortunately, in either of the two scenarios above making ISA payments would offer no benefit, as they aren’t included in assessing Child Benefit tax or loss of Personal Allowance.

At a glance… pension and ISA benefits compared

	ISA	Pensions
Instant access?	Yes – may be several days for any funds to be sold	Possible – no access before age 55 unless due to severe ill health / or protected retirement age
Contribution Limits	£20,000 p.a.	£3,600 gross or 100% of net relevant earnings (whichever is higher) subject to annual allowance limits (currently £40,000 but can be lower for high earners)
Tax environment	Tax-free growth	Tax-free growth
Tax relief	None	20% immediate relief available. Higher/additional rate taxpayers obtain further relief via self assessment
Death Benefits	Full value included in value of estate for Inheritance Tax purposes	Tax free on death benefits paid before deceased’s 75th birthday. Benefits will be subject to beneficiary’s marginal rate of tax if deceased was over 75 at date of death. Pension funds not currently included in value of estate for Inheritance Tax purposes

 

The above table is not exhaustive; there are other features and aspects to consider. There are also other investment vehicles available that may be more suitable than a pension or an ISA, depending on individual personal circumstances, while this is why it is always a good idea to seek professional advice. But, nevertheless, the benefits of pensions to those approaching or over the age of 55 are clear.

Accessing your savings before 55: is it a good idea?

If a saver is under the age of 55 and might need access to the capital before their 55^th birthday, then saving any surplus income into ISAs could be more beneficial.

What about tax on income from pensions?

Some dissenters may still argue that pensions are not attractive because any income in retirement is potentially taxable, while you can access your ISA without liability to tax – and at any time. But remember that 25% of a pension fund can be taken tax free and, if available, tax allowances are used carefully and income can be taken relatively tax efficiently. In addition, pensioners typically pay lower rates of Income Tax than they did while working so in all but the rarest of cases, the percentage tax paid on the way out is less than tax relief on the way in.

This then begs the question, what should I do with my current savings? Well, there certainly is an argument for using existing savings, ISAs or unit trusts to fund pension contributions. Remember, you can contribute up to 100% of earnings or £3,600 gross per annum, whichever is higher, subject to a maximum of £40,000 in a year. Savings will immediately benefit from the 25% uplift and invariably you can access equivalent – if not the same – investments in a pension as you can in directly held portfolios. More than ever, now is the perfect time to start reviewing your portfolios.

How Bestinvest can help

If you know your pensions need some attention or you just want to make sure you’re doing all you can, why not book a free call with one of our Coaches. We’ve also got a multi award winning, low-cost Self-invested Personal Pension – the Best SIPP* – which can be suitable for pension consolidation and as a home for new pension contributions.

If you're interested in getting started with an individual savings account, our Stocks & Shares ISA is a simple, low-cost account that makes it easy to invest. Not to brag, but we were voted Best ISA Provider at the City of London Wealth Management Awards 2020.

Examples of how tax or tax relief may apply are based on our understanding of current tax legislation. Whether any tax will be payable, at what level it is charged and whether you qualify for tax relief will depend upon individual circumstances and may change in the future. This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.

*SIPPs are not suitable for everyone. If you don’t want to invest across different asset classes or don’t think you will make use of the investment choices that SIPPs give you, then a SIPP might not be right for you.