Pensions vs ISAs - Which is Best?

Pensions vs ISAs – Which is Best?

As there are pros and cons to both investment types it can be complicated to know whether to invest in Pensions or ISAs so we have provided a simple guide to the main differences and how they may affect you.

Tax

One of the main benefits of a pension is that you get income tax relief on any money you contribute.  For example, if you are a basic rate tax payer and you want to add £1,000 into your pension, you would pay in £800 and HMRC would add £200.

There is no tax relief available when saving money into an ISA.

For both products, the growth on investments and income from dividends are free of Capital Gains Tax (CGT) and income tax as they grow however, only the ISA will be free of income tax when money is withdrawn. 

Usually only 25% of any pension pot can be withdrawn tax free (known as Pension Commencement Lump Sum (PCLS).  After the PCLS has been taken all further payments are taxed as income.

Investment Limits

Pensions have different limits regarding how much you can invest and still receive tax relief.  Each year you can contribute up the “annual allowance” (currently £40,000) or 100% of your earned income whichever is lower.  (There is also scope to use unused allowances from past years – ask us about the rather complicated rules!)  If you have no UK earnings then you can only contribute up to £3,600 per year. 

In addition to this, there is a “lifetime allowance” which caps the maximum value of your pension over your working life. 

With an ISA there is an annual contribution limit, currently £20,000 but you can hold an unlimited value.

Accessibility

You can usually access your pension when you reach the age of 55 (this may change).  You can then take the PCLS and the remainder is normally used to provide an income.  The options available include purchasing an annuity, which provides a guaranteed income for the remainder of life, or flexible drawdown, which gives you more choice.

You can draw on your ISA at any age (over 18).  All withdrawals are completely tax free and you can choose to make a large one off withdrawal or a series of smaller withdrawals.

What happens when I die?

Pensions usually fall outside of your estate and are therefore free of Inheritance Tax (IHT).  If you die before drawing your pension benefits, your pension may pay out a lump sum.  For a company pension this could be based on a multiple of your salary.  For personal pensions this could simply be the value of the fund on the day you die.

Pensions can now be regarded as intergenerational investments because you can pass down the pension to spouses and successors by nominating them to receive the funds on death.  (Newer schemes do this, some older ones don’t!) 

With an ISA, if you die, the ISA value is part of your estate and may be subject to IHT.  You can pass it to a spouse or civil partner as an additional ISA payment, on top of the normal limits – to avoid IHT on your ISA, talk to us about AIM Portfolios. 

Which is Best?

Essentially, a combination of ISAs and pensions will be suitable for most people.  We can discuss the right proportions for you.