ISAs versus pensions

It’s a common dilemma, which is better - an ISA or pension? In truth there’s a place for both and it’s easy to argue the case that we should all have both. But how you choose to invest your money is ultimately down to you, so here are some facts about ISAs and pensions to help make your investment choices easier.

1. If you want tax-efficiency

Both ISAs and pensions are a tax-efficient way to invest. They work in slightly different ways though.

If you pay into a personal pension or a SIPP, HM Revenue & Customs will top-up your contributions at your basic rate of tax. This means you only have to make contributions of £2,880 a year to have a total of £3,600 added to your pension pot.

When it comes to drawing your pension, there may be tax to pay though. (see No. 5 for more information).

Where ISAs differ is that they don’t allow you to claim tax relief on money going into them, but they do give you total tax exemption on any gains made within the ISA. So however much you build up in an ISA over the years, you won’t pay a penny of tax on any of it when you come to withdraw it (certainly not under current ISA rules anyway).

With both ISAs and pensions, it’s important to remember tax treatment depends on individual circumstances, and all tax rules may change in the future.

2. If you want flexibility

Pension savings are locked away until you’re at least 55, whereas with a stocks and shares ISA you can get your hands on your money whenever you want to.

So, if you already know you’ll need the money you’ve invested before the age of 55 - maybe because you have a mortgage to pay off, school or university fees to pay for, a wedding to contribute towards, or whatever else you know lies ahead, then putting that money into a pension is a bad idea. In that case a regular stocks and shares ISA is your better option.

Similarly, if you don’t know you’ll need the money for sure, but have a sneaking suspicion that you might, or just want the comfort of knowing you have some money to hand should you need it, then splitting your potential investments and putting some into your pension and the rest into an ISA might be a better idea.

3. If you want to keep your money out of temptation’s way

The fact that pension investments are locked away until you’re at least 55 is as much of an incentive for many investors as it is a deterrent for others (see no 2 above).

The fact that you have to leave your money invested over decades also comes with its own rewards. Not only does long-term investing have the added benefit of allowing time to iron out any dips or blips that may affect investments held for a shorter time, but there’s also the power of compounding to factor in.

Think of this like a snowball rolling down a hill. It gets larger more and more quickly, because the growth gets added to what's already there. The same can happen with your pension savings, as the growth in one year isn't just added to your original contribution, it also applies to all the previous years' growth that you've achieved. It’s not for nothing that compounding has sometimes been called the eighth wonder of the world.

4. If you want to invest more than £20,000 a year

For the 2017/18 tax year, the ISA allowance is a whopping £20,000. The maximum you can contribute to your pension and get tax relief on is more, at £40,000, but if you’ve already started drawing a pension, you will only get tax relief on a maximum of £4,000 a year.

Remember too that the annual allowance applies across all of the schemes you belong to. It’s not a per pension scheme limit, so if you have numerous pensions in your name, all the contributions you make to any of these pensions count towards the annual limit. So do contributions made by your employer, so make sure you don’t go over your annual allowance.

If you are going to breach the annual allowance, maxing-out your pension contributions first, before saving into an ISA, is a good way to take best advantage of the tax perks on offer.

5. If you’re relying on a lump sum to clear your mortgage

Since the so-called ‘pensions freedoms’ came into being, increasing numbers of people have seized the opportunity to get their hands on a tax-free lump sum when they reach the age of 55.

If you plan to do this, make sure you know the rules. You can take up to 25% tax-free, but further sums, which are classed as income for tax purposes, may incur income tax if your total taxable income falls into the basic rate tax band or higher.

Withdrawals from an ISA don’t incur tax, no matter how much you take out.

Important Information

The value of investments and income from them can go down as well as up, so you may get back less than you invest. This information and our guidance are not personal recommendations for any particular investment, product, service or course of action. If you are unsure of the suitability of an investment, you should speak to an authorised financial adviser. Investors should note that the views expressed may no longer be current and may have already been acted upon. 

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