Pensions and ISAs both offer tax advantages and form the foundation of any investment planning. The benefits of both types of investment increase as an individual’s marginal rates of tax rise. Owing to the tax advantages offered, both have restrictions on how much can be invested. Other eligibility and access restrictions also apply.
Whilst, ideally, individuals would want to maximise the advantages available from both products, many will not have sufficient funds to do so. How do they compare when the investor must choose between the two?
How do ISAs and Pensions compare to each other?
Taxation
With an ISA, the taxation is very simple: no tax relief is available on any contributions to an ISA and no tax is payable when funds are withdrawn.
The taxation of a pension is more complex with income-tax relief provided on eligible contributions at the investor’s highest marginal rate. When funds are withdrawn, 25% can usually be paid free of tax with the rest subject to income tax. The tax-free cash element can give a pension a significant tax advantage over an ISA. Even though the ISA allows access to funds at any time without a tax penalty, the pension has the potential for tax relief on both contributions and withdrawals.
Contribution
The maximum investment into an ISA is a straightforward £20,000 per tax year. The minimum age for a stocks and shares ISA is 18 and 16 for a cash ISA. There is no maximum age.
Contributions to pensions are usually restricted to the extent they benefit from tax relief. Tax relief on pension contributions is limited by the annual allowance with the standard allowance being £40,000 a year, but this can be as low as £4,000 for very high earners or those who have already accessed their pension benefits.
As well as the annual allowance, tax relief on personal, as opposed to employer, contributions is restricted to the level of a pension-scheme member’s earnings (or £3,600 if higher) in the tax year they are paid.
Access
The ISA has the clear advantage when it comes to accessing funds. Funds can be withdrawn at any time with no tax penalties. Investors can build up significant funds and withdrawal them as required without fear of tax consequences.
Pension funds can’t normally be accessed until the minimum retirement age (currently 55 but increasing to 57 from 6th April 2028).
Since 6th April 2015, once a member reaches the minimum age, pension funds can be accessed very flexibly. However, the withdrawal of funds still needs to be carefully managed as all withdrawals other than the tax-free cash portion are taxed at the individual’s marginal tax rate in the tax year they are received.
Death benefits
The full value of a client’s ISA investments will ordinarily form part of their estate for inheritance-tax purposes on death. Where there is a surviving spouse or civil partner, they can inherit an increased ISA allowance. Where there is no surviving spouse or civil partner, this allowance will be lost.
Pension benefits can usually be paid out free of inheritance tax where the scheme has discretion over who should receive them. In addition, all benefits are payable free of income tax where the member of the scheme dies under the age of 75. Where the member dies aged 75, or above, the benefits are taxed at the beneficiary’s income-tax rate(s).
The table below compares the net returns for the same net-cost investment of £1,000 for an ISA and a pension with different marginal tax rates. The final column compares the increasingly common situation where an investor will be a higher-rate taxpayer when the investment is made but will pay basic-rate tax on its withdrawal.
For these examples, growth on the investment is ignored.
| ISA | Pension basic-rate taxpayer | Pension higher-rate taxpayer | Pension additional- rate taxpayer | Pension higher- to basic-rate taxpayer | |
| Net cost | £1,000 | £1,000 | £1,000 | £1,000 | £1,000 |
| Investment | £1,000 | £1,250 | £1,667 | £1,818 | £1,667 |
| Net withdrawal | £1,000 | £1,063 | £1,167 | £1,205 | £1,417 |
| Pension v ISA % | + 6.3% | + 16.7% | +20.5% | +41.7% |
The pension has a clear advantage over the ISA at all tax rates. For the first three pension columns, this is due to the tax-free cash element: the higher the marginal rates of tax the greater the benefit it brings. The final column combines this advantage with the benefit of receiving a higher rate of tax relief on the contribution than the tax rate that’s paid on its subsequent withdrawal. This advantage can also benefit many basic rate taxpayers who may pay no tax on part of their pension income.
Lifetime ISAs
In addition to the standard ISA, since April 2017, there has also been the Lifetime ISA option, which could be seen as combining some of the advantages of pensions and ISAs.
The Lifetime ISA or ‘LISA’ is aimed specifically at those saving for retirement or for a first home. The LISA enables those between the ages of 18 and 39 at outset to save up to £4,000 in each tax year with the added benefit of the Government providing a 25% bonus on the contributions paid in a tax year at the end of that tax year.
Savers can make LISA contributions and receive the Government bonus from the age of 18 up to the age of 50. So, effectively, someone who opens an account aged 18 will be able to secure lifetime savings of up to £160,000 (namely £128,000 saved by them and £32,000 as Government bonuses). At age 50, permitted contributions must cease.
Funds can be withdrawn from the LISA at any time, but the Government bonus will be lost and a 5% penalty will be incurred unless the investor is over the age of 60 at the time of the withdrawal or the funds are to be used towards the purchase of a first home with a cost of up to £450,000.
Conclusion
ISAs offer simplicity and, in most cases, unrestricted access whereas pensions can provide significant levels of income-tax relief, which makes them relatively attractive for those wishing to save for retirement.
If you would like to discuss your ISA or Pension please contact your usual MWM contact.
Disclaimer:
Tax relief and the tax treatment of pension & investment funds may change.
The information included within this presentation is for general information only and is not intended to address the particular requirements of an individual. In particular, the information contained within the article does not constitute any form of advice or recommendation by MWM. The information should not be relied upon by individuals in either making or refraining from making any investment decisions. Where necessary, individuals should seek appropriate professional advice before acting on any of the information contained in this article.
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