Pension versus Isa: your future starts here
With the extensive changes to both pensions and Isas introduced last year by George Osborne, the two separate tax-advantaged wrappers have become a better complement to each other in many ways.
But with new tax-efficient investment opportunities come new dilemmas. Where should you save first? From which vehicle should you take income? Does the use of one make the other redundant?
One main factor to consider when deciding whether to save into an Isa or a pension is where you are in life. Below, we consider the pros and cons of saving into (and drawing from) an Isa, a pension or both at three different life stages.
EARLY CAREER: AGE 25-45
It is hard to deny that pensions have become the most attractive saving vehicle on the mar- ket over the course of the past 12 months. However, there remains one chink in a pension's armour: accessibility.
Unless you take a punt with a dodgy 'pensions unlocking' scheme - or scam, quite possibly - and risk having to pay 55% penalty tax, your pension savings are, in most cases, entirely out of reach until your 55th birthday.
This is why Isa providers have a horse in the race. For younger savers likely to need access to their savings before they reach state pension age, or as an emergency or medium-term fund at any age, an Isa becomes the best bet.
However, a new dilemma arises: you cannot put the same pound into both vehicles. Every deposit you make into your Isa – because you worry you might need it sooner rather than later – is one that's not benefiting from the tax relief you get on pension contributions.
Paul Garwood, director of financial planning at accountant Smith & Williamson, says that although putting money somewhere accessible is important, the precise split between pension and Isa will vary according to individual circumstances.
"If you have any uncertainties about upcoming demands on your finances, don't invest for the long term (in a pension). If you feel you might need this money in the next few years, keep it accessible."
Whatever you invest in, be it an Isa or a personal pension, it might help to think about the time of year you make your contributions.
Andrew James, head of retirement planning at Towry, says many people wait until the end of the tax year to invest. He adds: "But why not put it in at the start of the year, so you get an extra year's investment as it goes in? It can make a real difference over the years, because of the compounding effect."
Garwood agrees: "The other thing about leaving it to the end of the tax year is that, historically, it's a high point in the markets."
Research from Fidelity Personal Investing drives home the significance of increasing 'time in the market'. Fidelity found that investing £1,000 each year on 1 January from 2000 to 2014 would have yielded a pot of £35,487. In contrast, investing the same amount on 1 April over that period would have resulted in a pot of just £25,193 – a dramatic £10,294 less.
Garwood adds that investing monthly can round some of the market's sharper edges, through what's known as pound cost averaging.
Regular investing means your contribution buys more units when share prices are low and fewer as they rise. As a result, in some market environments, you may end up with more units for the same total investment. You also sidestep the risk of investing all your cash just before a market fall. Against this, if the market is rising, you are likely to miss out in comparison with a lump sum investor, as you won't be fully invested.
In terms of Isas, make sure your spouse or partner is using their allowance as well.
Pension and Isa basics
- £40,000 annual allowance
- £1.25 million lifetime allowance
- Marginal-rate tax relief added to your contributions
- Fund grows free of income or capital gains tax
- Pot can be accessed after age 55
- 25% tax-free lump sum can be withdrawn Further withdrawals taxed at marginal rate
- Can be inherited free of tax if you die before 75 (from April 2015)
- £15,000 annual allowance £15,240 from April 2015)
- Contributions from taxed income
- Savings split any way between cash and stocks and shares
- Fund grows free of income or capital gains tax
- No lifetime limit
- Withdrawals free of tax
- Can be passed on to your spouse (from April 2015)
- Proposal for third Isa type for peer-to-peer lending
MID-LATER CAREER: AGE 45-55
In the latter stages of your working life, the decision becomes more straightforward. Generally speaking, a pension should be your first port of call – provided you have some accessible savings.
You're unlikely to retire at 55 and probably won't want to draw from your pension pot while you are still working, but it's not too long to wait before you can access it if you need to – and the tax reliefs outweigh the benefits you get from an Isa investment.
If you are a higher-rate taxpayer, the benefits are particularly appealing, especially if, like most people, you will become a basic-rate taxpayer in retirement.
As an example, say you, as a 40% taxpayer, put £10,000 of taxed income into a pension (costing £6,000 after tax relief) and £6,000 into an Isa. The tax relief you receive on your pension contribution brings your pension pot back up to its gross value, £10,000. Your Isa will stay at £6,000. Let's assume both vehicles are invested in the same funds and their value doubles.
This leaves you with £12,000 in your Isa and £20,000 in your pension. When it comes to withdrawing money, for simplicity's sake, let's say you take it all at once from both places (from 6 April 2015 unless you already qualify for flexible drawdown).
Your Isa withdrawal is untaxed, so you can enjoy the full £12,000. Your pension will give you a 25% tax-free lump sum (£5,000), plus - if you have dropped back to the basic- rate tax band – 80% of the remaining £15,000, a total of £17,000 (£5,000 + £12,000).
So when all is said and done, you come out a full £5,000 better off from your pension than your Isa. But as Justin Modray of Candid Money points out, these calculations depend on whether that £15,000 withdrawal still keeps you within the basic rate tax band.
Basic-rate taxpayers also end up better off in the pension than the Isa. Putting £8,000 into a pension would get you a total of £2,000 tax relief so effectively costs £6,000. If that doubled to £16,000, it could still offer more than a similarly invested Isa, which would grow to £12,000. When you drew your pension, you would get the first £4,000 tax-free and pay 20% on the remainder (if within basic rate tax band), to leave you with £13,600, which is still more than your Isa.
Brewin Dolphin's head of financial planning, Nick Fitzgerald, suggests that a particularly tax-efficient move is to take advantage of 'salary sacrifice'.
He explains: "40 or 45% tax relief, plus the potential to reinstate child benefit and possibly benefit from your employer's 13.8% national insurance saving, can and often does, make the case for saving into your pension compelling (see box above for an example of how it can work.)
"Now add in the new access rules from April 2015 that treat us all as grown-ups by letting us draw our pension funds in the way that best suits us. So if you can't do both pension and Isa, do the pension while such tax incentives remain."
James says the only reason you should be saving into an Isa is if your pension is at risk of overflowing. "If you have funded your pension as much as you are allowed to," he maintains, "you should move to an Isa for retirement planning."
The lifetime allowance, which includes investment growth, not just contributions, is currently £1.25 million. Anything above that will probably be taxed at 55%. If you are in the enviable position of approaching your lifetime allowance limit, you could begin redirecting contributions, not only into your Isa but also into any unused Isa allowance belonging to a spouse or child. Be aware, though, that if you put money into someone else's Isa or Jisa, it belongs to them.
PRE-RETIREMENT AND RETIREMENT: 55 ONWARDS
If you retire before the state pension age of 65, you will have to turn to other sources of income, including your pension savings, which can be accessed from age 55. Keep in mind, though, that your retirement could last maybe another 40 years, so plan carefully how much you can afford to draw from your pot.
You will need to decide which sources you will draw your income from and whether you should start by taking the whole of your 25% tax-free lump sum from your pension. Note that from April, if you opt not to take the tax-free lump sum initially, only three-quarters of any sum then or subsequently withdrawn will be taxed.
Importantly, however, once you are drawing from your pension pot, taking too much at a time could bump you into a higher tax band. There is therefore an argument for drawing income from your Isa at this time: if you use Isa holdings for income, you don't pay tax on withdrawals and moreover you can leave your pension to grow for longer.
Indeed, this is where pensions and Isas really complement each other. Because Isas aren't taxed on withdrawals, if you are in this situation it makes sense to keep pension income under the tax threshold, and then turn to your Isa - maybe drawing capital as well as income to boost your cash flow while avoiding the higher rate tax bracket.
James says more and more people are taking income from their Isas, and this trend will continue among this generation of retirees, some of whom have been saving into Isas and their predecessors for 25 years.
"Because Isas have been around for a long time, you see people with a lot of money sitting in them. You could be building up a really big pot of money, especially if both you and your spouse are doing it," he says. "In October 2014 Barclays Stockbrokers alone had 63 Isa millionaires."
Death and taxes
In addition, from 6 April, pensions are also an effective way to pass your wealth on to your next of kin, so it's sensible to conserve them where possible. Although Isas can be passed on tax-free to your spouse, they will otherwise count as part of your estate, with the balance above the £325,000 threshold (£650,000 for couples) taxable at 40%.
Pension funds, in contrast – whether or not you have drawn from them – can be left to your heirs tax-free if you die before the age of 75. If you die after 75, income from the pension pot will be subject to tax at the beneficiary's marginal rate, and lump sums taxed at 45%.
At the end of all this deliberation, we are left in an odd position. One attractive option seems to be to hold some Isa investments but primarily save into a pension as you get older. You may well take the tax-free lump sum at retirement, but then leave the rest where it is for a while longer and take an income from your Isa, so that the pension can continue to grow and maybe even be passed on to your next of kin when you die. But to do that, you have to build up a good-sized Isa pot as well.
This feature was written for our sister publication Money Observer
A tax-efficient way of receiving staff benefits, where an employee agrees to forego a proportion of their salary for an equivalent contribution into their pension scheme or in exchange for company car, gym membership, childcare vouchers or private medical insurance. A salary sacrifice scheme is a matter of employment law, not tax law, and is often entered by an employee who is about to move into the higher 40% tax bracket.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. From April 2016, to qualify for the full state pension, individuals will need 35 years’ of NI contributions.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.