ISAs vs pensions – which is better for retirement?
ISAs vs pensions – as ISAs have become more popular for retirement, it's worth comparing them against private pensions that still have certain advantages.
Are you thinking about saving for retirement? If so, it’s worth asking yourself what your priorities are when it comes to saving and investing and whether you’d be better off using an ISA or a private pension.
The case against a private pension as the ideal savings vehicle for old age is based on increased complexity, especially when it comes to tax rules around pensions and pension consolidation. However, there are also things to consider when it comes to saving your retirement income in an ISA. We outline the pros and cons of both.
Private pensions pros and cons
There are a couple of areas where private pensions offer more benefits than ISAs.
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First, if you have the option of joining a pension scheme at work, doing so will mean benefiting from a pension contribution from your employer. In most cases, the minimum amount your employer must contribute is 3%. The current minimum total contribution is 8%, meaning you would then top your employer’s contribution up with 5%.
A pension also allows you to take 25% of your fund as a tax-free lump sum and offers a real advantage when it comes to inheritance tax (IHT) planning. In many cases, unused pension savings can be passed on to your heirs without counting towards the value of your estate.
The first thing to consider when it comes to private pensions is the allowances. Private pensions have an annual contribution allowance of £40,000 – which includes the value of your employers’ contributions as well as your own, and the value of tax relief. You can get tax relief on private pension contributions worth up to 100% of your annual earnings. If you’re a higher earner with an income above £200,000 a year your annual allowance becomes tapered and might decrease to as little as £4,000 for the tax year.
Then there’s the pensions lifetime allowance (LTA). This places a limit on how big your pension fund can grow tax-free.
The LTA applies to all your pensions, except for your state pension. If you fully withdraw your pension as a lump sum, you’d have to pay 55% tax on the excess over the LTA. This gets automatically deducted when it’s paid out. If you take your retirement fund as pension income, 25% is due immediately. Any further pension withdrawals are subject to income tax.
Something else to consider is private pensions’ lack of flexibility. You can only get your money once you turn 55. If you do start drawing down from your savings, your annual allowance falls to just £4,000. That’s a pain for the growing number of people looking to reduce the amount of work they do as they approach retirement. You also pay tax on private pension income.
Finally, if you’ve had many jobs throughout your life, you might also end up with many different pots of savings. Pension consolidation can be time-consuming and bureaucratic. All of these things considered, might savers be better off giving up on pensions altogether and using Isas instead to save for old age?
ISA pros and cons
ISAs are straightforward in that you get a contribution allowance of £20,000 a year. You can use that to buy a wide range of savings and investments. You then pay no tax on capital gains, interest or dividend income within the account.
You can also split your annual £20,000 contribution between different types of ISAs: cash ISAs, stocks and shares ISAs and lifetime ISAs. Additionally, you pay no tax on withdrawals. In most cases, you can take money out of an ISA as and when you see fit, irrespective of your age, so if you wanted to dip into your pot before you turned 55 you would be able to (although the rules are different with lifetime ISAs).
That said, there are a couple of areas where ISAs struggle to compete with pensions, namely when it comes to workplace contributions.
Opting for an ISA instead of a private pension will mean you’re missing out on that extra boost from your employers. Additionally, ISAs fall within the IHT net, potentially leaving your heirs with a nasty headache and a lot of paperwork.
ISAs vs pensions: the verdict
ISAs are certainly gaining ground on private pensions, but the case for them is not quite as obvious as it might appear. However further reforms to rules governing retirement savings, such as a move to flat-rate tax relief on contributions, advocated by some experts – could help them close the gap even further.
In an ideal world, savers would take advantage of both ISAs and pensions as they plan for old age, perhaps using up cash in the former first, in order to plan for IHT as efficiently as possible.
But for anyone lacking the resources to pursue both routes to retirement, pensions still retain an edge over ISAs.
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David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.
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