Pensions versus ISAs - Which is best?
Tuesday 25th January, 2022
As we head towards the end of tax year, my clients have started asking me that age old question: Should I fund my pension or ISA? Which is best?
In the article below, I will attempt to address this question, highlighting the advantages and disadvantages of each.
As always, the answer to this question can be quite nuanced and will often depend on where you are in your financial lifecycle and what you are trying to achieve. If you have any questions, please don't hesitate to give us a call at Atticus Financial Planning. We are always happy to help.
When I was a kid, my friends and I would have long debates about who would win in a straight fight between various superheroes, like Hulk versus Batman. Hulk had incredible strength, but wasn’t the sharpest knife in the draw after he has lost his rag and turned green. Batman had loads of gadgets and was incredibly intelligent, but had no real superpowers.
The debates would rage on for ages and arguments would vanish into more and more esoteric points of advantage, depending on how many comic books we had read and the level of our understanding of each superhero’s backstory. I suspect that many of my friends were eventually making up powers. I know I was.
Well, I am considerably older now, and one of the debates I get involved in now revolves around a comparison of the merits of two of the titans of the financial world. The Individual Savings Account (ISA) versus the pension.
In the following article, I will look to address this topic by first providing a brief summary of what ISAs and pensions actually are. Then I will highlight the advantages and disadvantages of each based on the following categories:
- Level of contribution
- Tax efficiency
- Investment choice
- Legacy benefits
Hopefully by playing this round of financial Top-Trumps, we can help you get an idea of which option is most suitable for you. However, if you still have questions at the end of it, please don’t hesitate to give us a call.
What is an ISA?
As mentioned above, ISA stands for Individual Savings Account. This is an important consideration, as an ISA cannot be owned in joint names. It is a tax allowance that is given to you in your individual capacity.
The ISA itself is just a tax wrapper in which various deposits or investments can be held. What makes it special is that any interest, dividends or capital gains achieved within the ISA are completely tax free and any withdrawals made from the ISA are also tax free.
There are a number of different ISAs available. These include:
- Cash ISA - which is for holding cash deposits such as instant access and fixed term savings accounts
- Stocks and shares ISA - which allows an investor to hold a portfolio of shares, corporate bonds and various funds within a tax efficient environment
- Innovative Finance ISA - which allow the investor to take advantage of peer-to-peer lending. By utilising a peer-to-peer lending platform, the investor is able to lend money to an individual or company in return for an agreed interest rate. The interest rate available to the investor is normally far higher than that from a cash account, but there is always the risk that the borrower will default
- Help to buy ISA - which helped first time buyers to save for a property purchase. This allowed the saver to save £3,400 in the first year and then £2,400 per year thereafter. The government will boost savings with a 25% top-up. These savings vehicles closed to new savers on 30 November 2019.
- Lifetime ISA - where the focus is either saving for a property purchase or for retirement. It can hold either cash or investments. The investor can save up to £4,000 per year into it. The government will add a bonus of 25% to the ISA contributions. Only those aged between 18-39 can open a Lifetime ISA.
I am often asked by people whether they are better off holding cash or investments within their ISA. As always, it really does depend on what you are trying to achieve with the funds being held. However, as a general rule I recommend using your ISA to hold an investment portfolio that has the potential to generate sizeable returns, rather than using the ISA to protect your cash savings from tax.
One of the reasons for this is that most people are very unlikely to have to pay tax on their cash savings. This is due to the fact that most of us have a Personal Savings Allowance (PSA) of £1,000 against which to offset tax on our cash deposits (This reduces to £500 for higher rate tax payers and £0 for additional rate taxpayers). Helen Saxon from Moneysaving Expert points out (Personal Savings Allowance. Earn up to £1,000 savings interest tax-free) that at today’s terrible bank savings rates you would need over £200,000 in the top easy-access savings accounts to generate a return that exceeds your PSA and causes a tax liability.
This differs substantially from investment portfolios, where the returns can be anywhere from 1% to 40% (if not higher) of the portfolio value in a positive year, depending on the nature of the portfolio and the risk being taken.
What is a pension?
There are a number of different types of pensions available. For the purposes of this comparison, we will be focussing on the bog-standard defined contribution pension, as opposed to defined benefit (final salary) pensions.
Pensions are another tax wrapper, which allows you to build up a pot of money, with the aim of funding your retirement. There are a number of tax benefits available from a pension and it can be funded either personally, by an employer, or by a third party.
There are a wide variety of different defined contribution pensions available. Most workers have a pension via a workplace pension scheme. These tend to be a basic pension wrapper with very low costs and a very basic investment offering. The pension funds are normally invested into a default fund, which may be life-styled to control the asset allocation depending on the member’s selected retirement age. These workplace pensions are now structured to meet the requirements of Auto Enrolment.
There are also personal pensions, which are pensions you set up yourself, separate from any workplace pension and employer involvement. These can range from incredibly basic and low-cost Stakeholder pensions which have a limited investment range and retirement options, all the way through to Self-Invested Personal Pensions, which have, as a general rule, the broadest investment offering and can hold a wide range of funds, shares, corporate bonds and even commercial property. Due to their greater facility and fund offering, SIPPs naturally tend to be more expensive, however, this is not always the case. Most SIPPs charge a fixed administration charge, as opposed to a percentage of the assets under management and can therefore be considerably more cost effective, especially for larger pension funds.
There are pensions which are adviser led, which require a financial adviser in order to utilise them and then there are other pensions which are designed to be run by the pension member themselves.
As you can see, there is a pension out there to meet pretty much every investor’s goals. It is often worth chatting to somebody in order to make sure that you select the right one for you.
Having briefly summarised what each wrapper is, I will now look at the differences between each of these options.
Level of contribution
This is a key difference between ISAs and pensions.
The annual ISA allowance is currently £20,000 per person per annum. You cannot contribute more than this in any tax year and if you do not use your ISA allowance in a specific tax year, it cannot be carried forward and will be lost.
For the majority of people, the pension Annual Allowance is capped at the lesser of:
- 100% of relevant UK earnings
- £40,000 per year
The £40,000 refers to the maximum gross level (including tax relief) of contribution that can be made to the pension in any one year.
Relevant UK earnings broadly includes the following:
- employment income, such as: pay, wages, bonus, overtime, or commission
- income from a trade, profession or vocation
- income from a UK and/or EEA furnished holiday lettings business, which is
chargeable under Part 3 ITTOIA 2005
- patent income
An individual with no relevant UK earnings can still make tax relievable pension contributions, but these are capped at £3,600 (£2,880 net).
Once the £40,000 Annual Allowance for the current year has been utilised, it is possible to carry forward unused Annual Allowance from the previous 3 tax years. It is therefore, theoretically possible to contribute £160,000 to a pension in one year, utilising the full current Annual Allowance, as well as the previous three year’s unused Annual Allowance. The individual making the contribution would need to have Relevant UK earnings of at least £160,000 to achieve this. In addition to this, they must have been a member of a UK registered pension over that period.
As we can see from the above, the level of contributions you can make into a pension each year is theoretically higher for a pension. However, it is important to remember that this doesn’t hold true for all people. For those with lower or no relevant UK earnings (e.g. retired people, people whose income come only from dividends or property rental, those with salaries of less than £20,000) it is likely that their annual ISA allowance will be higher than that of their pension allowance.
Both ISAs and pensions are remarkably tax efficient in their own way.
Many people say that it is hard to argue that the ISA isn’t the most tax efficient option of the two. The reason for this is that all gains achieved within the ISA are tax free, as well as all withdrawals from the ISA. What does this mean in practice? Let’s look at an ISA millionaire to provide an extreme example of the tax efficiency on offer. An ISA millionaire is someone who has built up over £1m over assets within an ISA wrapper. This is not as rare as you may think.
If they were to achieve a 5% return on their ISA investments, this would mean that they have received a £50,000 gain without any tax liability. If they were to draw the £50,000 out of the ISA wrapper each year, there would still be no tax to pay. Therefore, assuming a 5% annual return, an ISA millionaire can generate a tax-free income of at least £50,000 per annum from their ISA. They don’t even need to declare it on a tax return.
So, can a pension compete? The first thing to consider is that a pension member can claim tax relief on their pension contributions. Contributions to most ISAs (with the exception of Lifetime ISAs) do not benefit from any tax relief or government top-ups. The amount of tax relief is dependent on your tax status. I have demonstrated how this works below:
Standard rate taxpayers:
The pension member pays the contribution out of their taxed income. If they pay £100 into the pension, the scheme administrator will claim 20% tax relief from HMRC, which will be added to the contribution. £100/0.80 = £125. Based on this, the tax relief will be £25. The gross contribution will therefore be £125.
Higher rate taxpayers:
For higher rate taxpayers, they can claim an additional 20% tax relief, as their upper rate of income tax is 40%. They have received 20% reclaimed through the pension. They will now have to claim a further 20% via their tax return or ask that their tax code be adjusted, so that less tax is taken from their pay via PAYE.
If the tax relief is claimed via the tax return, the relief is provided by increasing the members basic rate tax band by the gross amount of the contribution. In this case the basic rate band would be extended by £125.
Without the extension of the basic rate band, their tax liability on this would be £50 (£125 x 40%). However, by extending the basic rate band, the tax rate is dropped to 20%, thus halving the amount of the tax liability to £25 (£125 x 20%). In this way, the higher rate taxpayer has received £25 tax relief added to his pension contribution and £25 tax relief through their tax return, which amounts to a total tax relief of £50 or 40%.
The main problem with this approach is that many higher rate taxpayers forget to reclaim the tax through their tax return. Fortunately, there is a time limit of four years to claim back any tax relief from HMRC. A claim must be made within four years of the end of the tax year that a member is claiming for.
If the pension contribution is made into your pension by your employer out of pre-tax income, the contributions are even more tax efficient, as there is no National Insurance deducted from the amount contributed.
Then, much like an ISA, the funds within a pension grow in a tax-free environment. This means that (with a few small exceptions) there is no tax on any returns generated while the funds remain invested within the pension. Pensions are long term investments, so the benefit this tax-free environment offers cannot be understated, when you consider the impact of compounding over decades the growth achieved on money that would have normally been paid out in taxes.
However, this is where the similarities between pensions and ISAs end in terms of tax efficiency. Where an ISA can be withdrawn in its entirety, without triggering a tax liability; a pension only allows 25% of its value to be drawn tax free. Furthermore, this tax-free amount is limited by the individual’s pension Lifetime Allowance. This is currently £1,073,100, which means the maximum tax-free amount that can be withdrawn (assuming no Lifetime Allowance protection is in place) from the pension is currently £268,275.
The remainder of the funds withdrawn from the pension will be subject to income tax at the individual’s marginal rate.
Mentioning the Lifetime Allowance also highlights another difference between pensions and ISAs, which is that there is no limit on the amount of funds you can build up in an ISA, while there is a limit on the tax relievable amount of benefits you can build up in a pension which is determined by the level of the Lifetime Allowance.
As we can see, both vehicles do offer a high degree of tax efficiency and have benefits that the other doesn’t provide. It remains to be seen from each individual’s personal circumstances and requirements, which will be the most tax efficient option over time.
While many may not think so, I think that accessibility is a key differentiator between the two tax wrappers we are comparing.
In practice, an individual can access the funds within their ISA (apart from the Lifetime ISA) at any time they wish without any tax penalties being applied. However, a pension cannot be accessed before age 55 (with the exception of certain age-related protections within the pension contract) unless the individual is suffering from severe ill health. This age limit on accessibility is to be increased to 57 in 2028.
In the absence of ill-health, any withdrawal before age 55 from a pension will be treated by HMRC as an unauthorised payment, which would be subject to taxes of up to 55% of the amount withdrawn or higher, if the fines paid by the provider are included.
Therefore, it is really important that the investor considers when they will need access to the funds, before putting the money into a pension. If it is to be before the pension retirement age, it makes sense to rather invest the funds into an ISA.
This is a factor that won’t be that important for the majority of investors. If the truth be told, ISAs are perfectly capable of providing access to the same range of investment funds as most pensions do. This means that for the basic investor looking to build a portfolio of funds, this can be done as effectively within an ISA, as it can be done in a pension.
Despite this, the fact remains that certain pensions do legally have the ability to offer access to investment options that cannot be held in an ISA. A key example of this is the fact that an individual can use their pension to purchase a commercial property. Therefore, a person could theoretically use the funds in their pension to buy the office that they work from. Then any rent paid for the office space would accumulate within the pension free from tax. Similarly, it would be possible to realise any growth in the value of the property without paying Capital Gains Tax on it.
I had a client who purchased a commercial property via her pension and then rented it out to a fast-food chain. Her biggest problem was that the rental income accumulated so quickly, that she was pushed over the Lifetime Allowance.
Alternatively, some pensions have the facility to lend money to a sponsoring company or to hold unlisted shares.
As a general rule, Self-Invested Personal Pensions and Small Self-Administered Schemes are able to offer a broader range of investment options than ISAs can.
Legacy / Inheritance Tax planning options
The one area that pensions tend to knock spots off of ISAs is the area of legacy planning.
While an ISA is not subject to income tax or CGT, the value of the assets in the ISA do still form part of your estate for Inheritance Tax (IHT) purposes and could therefore be subject to a 40% IHT charge upon death of the holder.
Since 3 December 2014, where a person holding an ISA passes away and that person was married or in a civil partnership, the surviving spouse or civil partner is entitled to an extra ISA allowance, which is equal to the value of the ISA(s) held by the deceased (even where the spouse or civil partner does not actually inherit the ISA). This is referred to as the additional permitted subscription (APS) allowance. In this way, ISA entitlement can be passed between spouses.
For pensions the IHT treatment is far more beneficial. For most pensions, their value is outside of the estate for IHT purposes.
In addition to this, (since 2015) you can now leave your pension to anybody you wish, without suffering harsh penalties that eat up 55% of the pension value. This means that what remains of your pension upon death can form a useful legacy to your loved ones. In the correct circumstances, the pension could transfer to them free from IHT, income tax or CGT. There may be a Lifetime Allowance charge, depending on the value of the pension, however, for most people this won’t be the case.
When one considers that a pension is often an individual’s most valuable asset, the ability to pass it on to your loved ones with little IHT liability can be a real advantage.
It is clear to see why ISAs and pensions are regarded as some of the most tax efficient investment vehicles available to UK investors. They each offer unique tax saving opportunities that over the medium to longer term can make a substantial difference to your returns and the level of withdrawals you can take tax efficiently.
The question of which is best can only be determined by your own circumstances and goals. If you would like to discuss this further to determine the best option for you, then please give us a call or book an appointment via our website.