ISA or Pension? Which is best?

Chancellor Jeremy Hunt surprised everyone with the changes to pensions introduced in his March 2023 Budget – but does it make them more attractive?

Investors have long debated whether their money is better off being invested in a pension, an individual savings account, or a combination of them both.

As always, the answer isn’t straightforward and depends on your personal circumstances, existing financial arrangements, and future goals.

Here we take a look at both routes, summarise the pros and cons of each approach, and explain what must be factored into any decision.

What is a private pension?

Let’s start with the basics. A pension is simply a way of investing money for your retirement in a tax-efficient way. It offers you the prospect of a lump sum pay-out and an income.

In the ‘good old days’ (baby boomer-generation and beyond), many pensions were in the form of defined benefit schemes, where the amount you received when you retired was based on your salary – up to two-thirds in some cases.

Most pensions today are defined contribution schemes. This means what you eventually receive will depend on how much you’ve invested and the performance of the chosen investments.

Pensions are available through a number of providers. The types of assets to which you have exposure will depend on which firm you have chosen.

As Fidelity explains, money saved into a pension comes with the significant benefit of enjoying decent tax relief. “Pension contributions are boosted with 20% tax relief by the government – and more if you’re a higher or additional rate taxpayer,” it stated.

This is very attractive. “A £1 contribution today effectively costs 80p if you’re a basic-rate taxpayer, as little as 60p if you’re a higher-rate taxpayer, or 55p if you pay additional rate tax,” it added.

Other pensions

Before we move on, it’s worth highlighting other types of pensions. For example, the state pension from the UK Government currently pays out £185.15 per week to those who have clocked up enough years of National Insurance Contributions.

The state pension age is under review but is expected to rise over the coming years. Your expected age of retirement can be found here. You can also see how many years’ of National Insurance contributions you have accumulated on the HM Revenue website.

There are also workplace pensions set up by employers. The biggest advantage of these schemes is that your employer will be making contributions to your overall pot. This is effectively free money.

What is an Individual Savings Account?

An Individual Savings Account (ISA) is a tax-efficient wrapper that shields your savings and investments from income or capital gains tax.

There are four types of ISA: cash, stocks and shares, innovative finance, and Lifetime. Currently, up to £20,000 can be put in such accounts during each tax year, which runs from 6th April to 5th April.

The most popular ISAs for longer-term investors are stocks and shares ISAs, and Lifetime ISAs, with the latter being subject to more restrictions. For example, a maximum of £4,000-a-year can be put into a Lifetime ISA. You also have to be at least 18 years old and under 40 years old to open one, although payments can be made until you hit 50.

A relaxation of the rules governing ISAs, which were originally introduced back in 1999, has made them increasingly flexible and attractive to potential investors.

What are the similarities between pensions and ISAs?

Both pensions and ISAs enable people to save for the longer-term and the importance of having some provision for later life can’t be overestimated.

They both share the goal of building up a pot of money that can be used in a variety of ways, whether as a lump sum pay-out or used to supply a steady stream of income.

The two solutions will also be invested in the same types of assets, which means they can be subject to similar levels of volatility and uncertainty.

Finally, both pensions and ISAs have tax advantages that make them both attractive solutions for those looking to invest over the long-term.

What are the main differences?

While they both have tax advantages, there are key differences when it comes to the amounts that can be invested, the available tax relief, and access to the cash.

Firstly, pensions are more complicated as far as the various tax thresholds and allowances are concerned so you’ll need to familiarise yourself with the rules.

For example, the Government has just announced a series of pension reforms that will take effect from 6th April 2023. This will see the annual allowance – which is the total that can be paid into the pension pot during a tax year – increasing from £40,000 to £60,000. Individuals can still carry forward unused annual allowances from the three previous tax years.

In addition, the Lifetime Allowance – the overall total maximum you can have in your pension pot – is also due to be scrapped.

According to Richard Buxton, manager of the Jupiter UK Alpha fund, this came as a surprise. “A benefit to higher earners, it remains to be seen if this will indeed stem the early retirement of NHS doctors it is in theory targeted at,” he said.

More broadly, investors can’t get access to their pension savings as easily as they can in an ISA. While the rules on accessing pensions were relaxed a few years ago, you still have to wait until age 55 (going up to 57 from 2028), before getting your hands on the money.

With a stocks and shares ISA or an innovative finance ISA you can access the money immediately. With a Lifetime ISA you can only access the money immediately if you are buying a first home. If the money is to be used for anything else, you have to wait until you are 60 unless you are willing to pay a 25% charge.

And while you won’t pay any income or capital gains tax on the money you make in an ISA, there are tax implications on the eventual withdrawal of your pension savings, according to Standard Life. “Any income or withdrawals you take from a stocks and shares ISA are tax-free,” it stated. “With your pension you normally get 25% tax-free and then any withdrawals above that are subject to income tax.”

The recently announced changes has seen the tax free cash limit capped at 25% of the current lifetime allowance of £1.073m, which puts it at £268,275.

How to choose

A final decision on whether you should be investing in a pension or an ISA will depend on your personal circumstances and what you already have in place. For example, if you already have a workplace pension and want the flexibility of accessing savings sooner than your mid-50s, then an ISA may be a wise option.

Conversely, if you are self-employed and don’t have a workplace pension, then locking in some longer-term provision could be a better move. Any excess money could then be put in an ISA.

Of course, you can have a number of solutions in your overall portfolio. According to HSBC, it makes sense to join your workplace pension and benefit from the effectively free money.

“If you can afford to, it also makes sense to pay into a pension and invest some funds in a stocks and shares ISA,” it stated. “In that way you can enjoy the tax and long-term benefits of a pension and have some money set aside in investments that are more accessible.”

_{Photo by Jon Tyson on Unsplash}