Are ISAs a better alternative to pensions?

Last updated: Sep 25th, 2013
Feature by Ceri Jones

Your choice of tax-efficient vehicle is one of the first dilemmas of saving, and often the choice is between an individual savings account and a pension.

In reality, most people should spread their savings between the two, so they have funds they can access if they need to in an ISA, while also taking advantage of the full income tax relief on pensions.

ISAs are certainly more flexible in several ways and this has made them extremely popular in recent years, particularly as distrust of pensions has grown. A major grouch about pensions is that they must be converted into an annuity (a monthly payment plan) or accessed through an income drawdown plan.

Annuities

Buying an annuity is currently dreadful value and looks set to remain that way as the Bank of England is committed to keeping interest rates down and life expectancy continues to rise. On average, it takes someone drawing an annuity some 20 years just to get their money back, although enhanced rates are available for those who shop around, especially if they have a medical condition.

For a 50% taxpayer, however, the tax relief on pension contributions is a serious uplift - after all it means that you can make the maximum £50,000 annual contribution for just £25,000.

A pension is also attractive for the many taxpayers who pay higher-rate tax during their working lives and then only pay basic-rate tax in retirement. As a rough rule of thumb, you will pay higher-rate tax in retirement if your pension fund exceeds £1.5 million at today's rates, assuming you take your entitlement to 25% tax-free cash.

If you do expect to pay a higher rate of tax in retirement you should also max out on ISAs first with the full £11,520 allowable annual investment, which will be tax-free on disposal and have no bearing on your age allowance (the income you can be paid before paying tax in retirement). The pension income can then be set against the age allowance, which this tax year is £10,500 for the over 65s rising to £10,660 at age 75.

In practice, if you hold a mixture of pensions and ISAs, with careful forward planning it may be possible to make considerable tax savings by using them at different times.

Find the best annuity rate for your circumstances

Start with ISAs and move to a pension

Young people on an upward career path might benefit from saving in ISAs initially, and later transferring the accumulated sum to a pension when they start paying higher-rate tax so that at that juncture they can receive higher-rate tax relief on their entire accumulated pot, says Standard Life head of pensions policy John Lawson.

"For example, if you saved £5,000 annually into a pension for 20 years, paying basic-rate tax for 15 years and 40% for five, you would have a lump sum of just under £193,459, which would buy a pension of £11,215. This is based on past capital growth of the FTSE All-Share index," explains Lawson.

"However, if you saved into an ISA for 15 years and then began to siphon this money into a pension once you had paid higher-rate tax, you would have £236,298, making you £42,839 better off without saving a penny more. This would buy you an extra £2,488 worth of pension income at least - possibly more, depending on your age and state of health."

Sharing pension contributions between a couple can help as this doubles the age allowance to £21,000 of tax-free income in retirement. Even if one spouse does not earn anything, it is possible to contribute up to £2,880 a year into a pension on their behalf which becomes £3,600 with automatic tax relief.

Employer pension contribution

The other big benefit of a pension is that employers often contribute and this will be mandatory in future as the government has legislated that every employer should offer a pension scheme to its staff, starting with big employers this October and smaller firms over the next few years.

Initially these will be minimal, requiring employers to contribute 1% of an employee's salary to his or her pension plan, rising to 3% by 2017. In addition, many large employers offer to match additional member contributions, which is effectively a pay rise.

If you elect to have a pension through a salary sacrifice scheme you can also avoid paying national insurance. For a basic-rate taxpayer this means tax relief at 20% on the contribution, plus 11% national insurance saving. Some larger employers will pay into ISAs on behalf of their employees as part of a flexible benefits package, but it is not tax efficient.

Many investors think ISAs trump pensions in relation to inheritance tax because on death, the assets held in ISAs fall into your estate and can be passed on to your dependants.

In contrast, HM Revenue & Customs takes a tough stance on attempts to pass on pension funds to beneficiaries and levies a cumulative tax charge on dependant death benefit through drawdown at 55%. And if the pension has been converted into an annuity, the insurer keeps anything left in the pot when the policyholder dies.

If you die before retirement, however, pensions are actually more attractive than ISAs because normally the money is paid 100% tax-free to your estate or spouse and, as most pensions are written in trust it is not included in any inheritance tax calculation.

There are also other considerations that require some crystal-ball gazing, such as whether current tax attractions will continue to exist in their current format or whether you believe the government will not be able to resist the temptation to tamper with them. It is probably only a matter of time before tax relief at the top rate will be abolished and the 25% tax-free cash could also be in peril.

Minimum retirement age

In addition, who is to say that the minimum retirement age will not again be raised from its current age 55? It was last hiked from age 50 in 2010 and the government is increasingly concerned that life expectancy is continuing to escalate.

Similarly at the moment a pension pot pre-retirement will not affect most means-tested benefits, such as income support, but not long ago pension savings were protected in bankruptcy, and this has already been changed.

Personal pensions and ISAs can invest in a wide range of funds while ISAs and a slightly more sophisticated type of pension called a self-invested personal pension can also invest in stocks and shares. "Clearly both have their attraction when building long-term wealth in that although ISAs don't offer initial tax relief, they do grow virtually free from tax and you can take income or withdrawals in the future free from income and capital gains tax," says Steve Wilson, director at Alan Steel Asset Management.

One neat strategy is to invest your ISA in high-growth assets such as equity funds until retirement and on retirement to switch it to fixed interest such as cash and bonds, that will pay a tax-free income.

SIPPs

SIPPs are useful for individuals with several pensions from previous jobs looking to consolidate their funds into a single manageable pot. They are available in two versions - SIPP Lite, a cheap and cheerful version primarily for investing in funds, and a full SIPP for financially astute investors who want to manage their own portfolios. Full SIPPs can invest in an array of sophisticated assets such as structured products, derivatives, hedge funds, traded endowments and, most significantly, commercial property.

Commercial property is a popular option for business owners who want to buy their business premises tax-efficiently within their pension. Tax relief on contributions boosts the capital available to buy the property, and it's also possible to borrow up to 50% of the fund value.

The big restriction for investors looking to invest in shares in an ISA remains the ban on junior companies that trade on the Alternative Investment Market (Aim). However, SIPPs can invest in Aim shares.

For higher-rate taxpayers with a taste for start-up companies, and higher risk, there are venture capital trusts that offer income tax relief of 30% on a maximum investment of £200,000 per tax year when you buy newly-issued shares. These are for investors looking for potentially higher returns and can stomach the higher risk of funds that invest in smaller companies not listed on the stock exchange.

What's right for you? Pros and cons of ISAs and pensions

ISA

  • The most you can put in to an ISA is £11,520 in the 2013-14 tax year, and up to £5,760 of this can be in cash.
  • You pay no income tax on withdrawals from an ISA and any profits from investments are free of capital gains tax.

Pension

  • The most you can put in to a pension is currently £40,000 a year and your accumulated pot must not exceed the lifetime allowance, which is £1.25 million (excluding state pension). 
  • The money you pay into a pension receives a tax rebate, with your contribution rounded up automatically if you are a basic-rate taxpayer or non-taxpayer.
  • A pension fund grows tax-free but is taxed at your highest marginal rate when you take the benefits. You can usually take up to a quarter of your pension fund as a tax-free lump sum.
  • The compounding effect over the years on the tax relief element you've received in your pension is one of the major advantages of a pension over an ISA.

This article was written for our sister publication Money Observer.

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