For anyone looking to save over a significant period, making sure your investments are in the right place is one of your most critical decisions.
The two most popular vehicles are pensions and ISAs – but which is better for your long-term investments?
The answer for most investors is that both warrant a place in your portfolio for different but equally important reasons.
However, the key factor that leads many people to choose ISAs over pensions is their flexibility; you can access the money in an ISA at any time if you need to, but once you make a contribution to a pension, you cannot touch that money until you are 55.
This puts many younger savers off, which is a shame, because you can build up sizeable pension pots by the time you retire with smaller contributions than you could in an ISA - assuming both enjoy the same investment performance.
This is because income tax relief is given on your pension contributions, but not on your ISA contributions. The difference is vital for determining the eventual size of your savings pot. Here we explain why.
Tax breaks on the way in
Both pensions and ISAs have generous tax breaks that make them attractive choices for savers, but the tax breaks work in different ways.
Pensions give their main tax break “up front”, with income tax relief added to your personal contribution when you pay into your fund. The precise amount of this tax relief depends on the size of your contribution and your marginal rate of income tax.
For example, a Higher Rate taxpayer only needs to pay £60 into a pension to make a £100 contribution, assuming the full 40% income tax relief is available. 20% relief is added initially with up to a further 20% being reclaimed via your tax return.
Similarly, a Basic Rate taxpayer only needs to pay in £80 to make a £100 contribution, once the 20% tax relief has been added. This is a very generous tax boost and means you are essentially given free money to be invested and grow in the stock market, and this can mean a larger fund compared to ISAs, all other things being equal.
Tax breaks on the way out
ISAs, on the other hand, allow you to withdraw your money, complete with all investment growth and interest earned, completely free from tax.
You may have a smaller fund compared to a pension, but Higher Rate taxpayers will need to pay up to 40% income tax on pension withdrawals in excess of any tax-free cash entitlement, whilst those withdrawing from ISAs will have no tax to pay at all.
How much can you pay in?
Pensions have an annual allowance of £40,000 which is tapered for individuals with taxable incomes for a tax year of greater than £150,000. Within this allowance, tax relief on personal gross contributions is restricted to the higher of £3,600 or 100% of your relevant UK earnings. You can pay more, but you won’t receive tax relief.
The annual contribution limit on ISAs in the 2019/20 tax year is £20,000, which can be invested in cash, stocks and shares, or a mixture.
It’s important to bear in mind the existence of flexible ISAs – accounts you can withdraw from and return equivalent funds to in a given year without effecting your allowance. Not every ISA offers this option, and as we have seen they behave differently to pensions – but this is an important capability to factor into your plans.
There is no lifetime limit on the amount you can build up in an ISA, but there is a cap on the amount you can accumulate in a pension fund without facing a tax charge, known as the “lifetime allowance”, which is currently £1,055,000.
Passing on your wealth
Finally, you should also consider the implications for passing on your wealth.
Pensions can usually be passed on to your heirs completely free from inheritance tax. The values of ISAs, in contrast, are counted as part of your estate, so are potentially subject to 40% Inheritance Tax.
As you can see, it therefore would make sense in most instances to arrive at retirement with a combination of money in both pensions and ISAs so that you can make use of your retirement savings in the most efficient way possible.
Liz Alley, Divisional Director of Financial Planning at Brewin Dolphin, says: “It is not a question of pensions being better than ISAs or vice versa, it is a matter of assessing personal circumstances and taking advice about which product best suits your needs. However, in most cases, the best answer is to have both pensions and ISAs in your portfolio so that you maximise your choices in retirement, which can ultimately lead to a better outcome for you and your family.”
The value of investments and any income from them can fall and you may get back less than you invested.
Please note that this document was prepared as a general guide only and does not constitute tax or legal advice. While we believe it to be correct at the time of writing, Brewin Dolphin is not a tax adviser and tax law is subject to frequent change. Tax treatment depends on your individual circumstances; therefore you should not rely on this information without seeking professional advice from a qualified tax adviser.
No investment is suitable in all cases and if you have any doubts as to an investment's suitability then you should contact us.
The information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.
The opinions expressed in this publication are not necessarily the views held throughout Brewin Dolphin Ltd