As you may well have heard, ISAs are overtaking pensions for the first time ever in terms of popularity with savers. According to the Office of National Statistics, we collectively put £14.3 billion into our personal pensions in the 2010/11 tax year. This sounds fairly substantial until you compare it with the £15.8 billion that the British public invested in stocks and shares ISAs the same year.
While pensions have traditionally been seen as a safe way to save for retirement, successive changes to the system coupled with the lack of security caused by the demise of final salary schemes, has understandably left many savers wondering if an ISA might be a better home for their hard-earned money. If you’re not sure where is best to house your retirement savings, read on to find out some of the benefits and drawbacks of pensions and ISAs.
ISAs – the positives
- They’re a simple, flexible, tax-efficient way to save or invest
ISAs work in a very simple way. Each eligible UK citizen or Crown employee has an annual tax-free savings allowance – for 2012/13 it’s £11,280, and this will rise to £11,520 after 6th April 2013. Of this allowance, you can deposit half in a cash ISA and the rest in a stocks and shares ISA. Alternatively, you can place the entire allowance in a stocks and shares ISA.
The tax benefits of an ISA are easy to understand, too. The interest you earn on money saved in a cash ISA is exempt from income tax, while the income you earn from an investment ISA is taxed at just 10%.
- They offer instant access
Unlike a pension, which is only accessible after a certain age, an instant access ISA offers withdrawals whenever you need the cash. Some ISAs offer fixed rates or specific investment terms that require you to lock money away for a period of up to a few years, but they’re still much more flexible in terms of timescales than pensions.
- They take some of the hassle out of tax in later life
If you choose to use savings from ISAs as a source of income during retirement, this won’t impact on certain age-related benefits, and there’s no need to declare it on a tax return. Additionally, unlike pension payouts, any money you’ve saved in an ISA for your retirement won’t be taxed when you eventually use it. This means that, when it comes to ISA savings, you don’t have to worry about potentially higher income tax rates when you retire.
ISAs – the negatives
- They don’t offer tax relief
Although ISAs are free from income tax, they lose out to pensions in that they don’t offer the same automatic income tax refunds. While this might not be such an issue for basic rate taxpayers, those in the higher tax brackets could stand to lose out - additional rate taxpayers receive 50% income tax relief on pension contributions, as opposed to 40% on cash ISAs..
- They have relatively low annual deposit limits
ISAs have much lower annual contribution limits than pensions – currently, these limits stand at £50,000 for pensions versus £11,280 for ISAs. This may not be an issue for those who begin saving for retirement at a young age, but for those who’ve left it until their forties or fifties, it’s unlikely they’ll be able to build up a comfortable sum by the time they retire using an ISA alone.
- No employer contributions
ISAs rely entirely on your own contributions. In this respect they differ from workplace pensions, which allow you to receive additional contributions from your employer, as well as the option of bypassing your 10% national insurance payments via salary sacrifice schemes. Even if you’re happy with your ISA, once your employer starts auto-enrollment into pension schemes you’ll effectively be turning down a pay rise if you opt out.
- They can affect your benefit entitlement while you’re still working
For people who are pre-retirement, having savings or investments in an ISA has the potential to affect various types of benefits – for example, if you have savings beyond a certain level, you might not qualify for income support. However, if you have a pension fund, this won’t come into consideration.
Pensions – the positives
- They offer long-term tax benefits
When you pay money into a pension, the Government refunds the income tax you paid on it, up to certain limits (see below). You automatically get the 20% that would have been taken in income tax back from the Government. Higher rate taxpayers can reclaim an extra 20%, while top rate taxpayers can reclaim 30%. This means that pensions can offer particularly good tax benefits to those who pay higher taxes. As an illustration of this:
For basic rate taxpayers…if you put in £80 you’ll receive £20 in tax relief, giving you £100
For higher rate taxpayers…if you put in £60 you’ll receive £40 in tax relief, giving you £100
For additional rate taxpayers…if you put in £50 you’ll receive £50 in tax relief, giving you £100
While this level of tax relief can look attractive, especially to higher rate taxpayers, it’s worth bearing in mind that when you come to use your pension in the future you’ll have pay income tax on it. But on the flip side, remember that unless you retire very comfortably, you’ll probably be on an income that qualifies for basic rate anyway, so you’ll still be making an overall saving on tax. For example, if you’re currently in the 40% tax bracket you’ll be paying no income tax on pension payments right now, and only 20% income tax when you claim them back in the future.
- They offer higher contribution limits than ISAs
Unlike ISA deposits, which are currently capped at £11,280 per year, pensions have high annual contribution limits. You’re permitted to contribute up to 100% of your income per year, up to an annual maximum of £50,000. Overall, you have a lifetime pension allowance of £1.5million.
- They can be arranged through your employer
Many companies offer a staff pension scheme, which is often taken off you monthly salary, pre-tax, and includes an employer contribution. Since October 2012, the Government has been in the process of rolling out auto-enrolment staff pension schemes, which means that all employers will have to contribute to workplace pensions in the future. Workplace pensions can be a straightforward and convenient way to save for your retirement – you don’t have to do anything except sign up, and the contributions will be taken directly from your salary.
In addition, most employers will match, if not exceed, your personal pension contribution. If you contribute 4% a month towards your pension direct from your salary, your employer might contribute another 4%, or even 6%, on top of that. If your employer offers a salary sacrifice scheme, you can save another 11% on national insurance. Effectively, workplace pensions offer a pay rise to save up for the future, so they’re worth serious consideration.
- They offer tax-free growth
Like and ISA, money that’s in a pension grows in a tax efficient way, compared to other types of savings or investments. However, as with all tax benefits, this is subject to change.
Pensions – the negatives
- They’re a closed book until you hit 55
This can be something of a mixed blessing. On the one hand, unlike an ISA, a pension fund doesn’t allow you to dip into it for those ‘essential’ expenses. This, in theory, means that you’re less likely to look back regretfully from the relative wisdom of retirement and wish you’d thought a bit more carefully about your purchases.
On the other hand, if a real crisis does arise – for example, you need to make emergency repairs to your home – you can’t touch your money. And when you turn 55, in most cases, you need to buy an annuity that pays you a set (taxed) income for the rest of your life – so it’s unlikely you’ll be able to splash out too much in one go.
- They're complicated
Many people find pensions difficult to understand. There are so many options to choose from that even working out basic retirement plans – simply put, how much you need to save now for the lifestyle you want later – can become a minefield.
- They’re subject to Government whims
Successive governments have introduced various changes to the pension system – indeed, a new shakeup of the State pension system has just been announced. These changes, beneficial or not, can be very confusing for savers. With an ISA, on the other hand, it’s simple – your money goes in, grows tax-efficiently, and that’s it. Of course, ISA rules change too, but historically it’s pensions that have been subject to the majority of Government involvement.
So, which is best?
The short answer is, that really depends on you! Everyone has different savings goals – some of us are at the stage in life where we’re saving with retirement firmly in mind, while others have shorter-term goals such as starting a family, buying property, or funding education. If this is the case, an ISA might be a good way to save some of your money for the short term, while at the same time you contribute to a pension pot. Jason Witcombe, of Evolve Financial Planning, argues that basic rate taxpayers are better off sticking with ISAs. “Why would you tie money up in a pension for 20% tax relief” he asks, “when the odds are you will pay at least 20% tax in retirement?' However, the majority of financial advisers seems to adhere to the rule that for most people, there are benefits to not putting all your eggs in one basket when it comes to retirement savings. As with all investments, it’s best to seek independent financial advice if you’re unsure.