The battle – Pension Versus ISA

Hello, I am a fool and I hadn’t been saving anything into an ISA until January 2015.  All of my savings were either in cash (outside of an ISA for a better rate), company share options or the company pension.

So what do you do?  Save into a pension or an ISA?

A pension gives us tax relief on our contributions so we have more money going into savings in the first place, and any withdrawals are then taxed as income. Woop!  An ISA, on the other hand, has already been taxed and all contributions thereafter are tax free, both on capital gains and any income.  Woop!  But which is better?  The pension looks like it at first glance, there is more money to compound right from the off as we get tax relief from the off.

Lets start with a simple numerical example.

Columbo has £10,000 to invest as a lump sum.  Assuming a 5% return, a 10 year horizon and 3 various tax bands (before being whilst working and after being during retirement)…

Pension or ISA
Pension Vs ISA

So where our tax before and after is the same, there is no difference in the net fund we have at the end  of the period.

But, where our tax is greater whilst working, compared to retirement, the pension wins.  This could quite easily be the case, for example if you are a higher rate tax payer whilst working it is possible that in retirement you will pay normal rate tax (or even no tax if your income was below the annual tax free allowance).  I didn’t include examples where the tax rate is higher in retirement, as that seems pretty unlikely.

The Pension seems an obvious winner here.  But this is a very simple example and there more powerful forces at work… let battle commence.

The Pension’s Jab: More effective tax relief
See above 🙂

The Pension’s Uppercut: Employers Contribution
The ever sneaky pension becomes even more valuable when you include the employers contribution.  For example your employer may match your contribution up to 5%, which means for each 5% contribution that you pay, your pension actually receives 10%.  You get a 100% return on your money immediately.  A big win for the Pension and one that’s hard to ignore,

The Pension’s X2 Combo: The Tax Free Lump Sum
The current rules allow you access to 25% of your pension pot tax free, after normal retirement age.  This money could then be drip fed into an ISA each year for further tax free growth.  Of course this is not written in stone.  It’s more likely to have been written in flour in the middle of a very busy and very windy street.  The government may well take this benefit away in the future.

The Pension’s Round House Kick to the Face: Drawdown
New rules now mean you aren’t forced to by an annuity on retirement and you are free to access and invest your pension as you see fit.  This is a great improvement to the flexibility of the Pension.

The Pension’s Baseball Bat to the Kneecaps: Higher annual contribution limit
You can only put £15,000 into an ISA each year.  The tax free limit for a pension is currently £40,000 a year.  A small win for the pension here.

The ISA’s Hadouken: Flexibility


(Ignoring SIPPs here).  The ISA is generally much more flexible than an employers pension, that may only offer you access to a limited number of managed funds…which could have an hefty AMC or a shite fund manager.  By investing in shares/funds in your ISA you generally have much more flexibility.

The ISA’s Holy Hand Grenade: Diversification
You don’t have to hold all of your ISA investments with the one broker.  In my eyes this is a huge benefit.  Diversification shouldn’t just be limited to which shares/sector/fund/country you are investing in, but the providers themselves.

By diversifying our holdings among multiple providers we are protecting ourselves against losing all of our money should a single provider go bust.  Some of your money would be safe guarded anyway by FSCS compensation, between £50k and £85k depending on the provider.

(EDIT: in the above comparison I was only referring to the company pension situation, where you need to contribute to the employers scheme in order to benefit the employers pension contribution.  If you are investing in SIPPs then you could have multiple providers.  Result!)

The ISA’s 1UP Mushroom: Access
You can’t get access to your pension before you are at the normal pensionable age (currently 55), at least not without heavy taxes being taken.  As UTMT said, “Tax is a shit”.  The ISA is not subject to the same rules as the Pension here, and you are free to access your savings earlier if needed….say for financial independence.  This is a huge win for the ISA.  (Although, if you keep raiding your savings with your greedy wee hands the ease of access could be a disadvantage.)

Conclusion
They both have their merits and there isn’t an obvious winner.  The Pension seems a more tax efficient choice, but it is burdened by additional regulation which could change at the governments whim.  It does seem a riskier choice.  The ISA is a much more flexible choice and simpler.

I am going to reduce my Additional Voluntary Contributions (AVC’s) and only contribute what I need to get the maximum employers contribution.  This will be a nice bonus when I hit the pensionable age.

The recent payrise and the amount that was going to AVC’s will now be pounded into a stocks and shares ISA.

By using both I can max out on the company’s contribution (effectively a payrise or free money), get some extra diversification (both regulation and provider) and get the extra flexibility of an ISA.

What say ye?  Pension or ISA?  What have I missed?

Spend less, save more and escape the Horde

Mr Z

11 thoughts on “The battle – Pension Versus ISA

  1. Under The Money Tree

    Well, seeing as I'm planning on retiring well before 55 i'm trying to maximize my ISA payments. That said the tax breaks from pension contributions are not to be sniffed at so a balanced approach is probably best (as always)!

    Reply
  2. weenie

    Great and original post of the usual Pensions vs ISAs argument – I enjoyed that!

    I say invest in both – I'm not a higher tax earner so don't get the full benefit of tax benefits but there is still some tax benefit.

    At the moment, the amount is split 50/50 between my SIPP and ISA but I think I'll eventually chuck a bit more at my ISA.

    Ryu's Hadouken? Chun Li was my fave character and her Spinning Bird Kick!

    Reply
  3. Cerridwen

    I'm stuffing most of my savings into my SIPP at the moment as I'm already over 55 and intend to drawdown in a "no-tax" environment to fund the years before my DB pension becomes payable. If I had more to invest though I would look at the balance between the SIPP and the ISA as the tax benefit of the SIPP disappears once you are drawing down more than your tax free allowance.

    Great summary of all the ins and outs.

    Reply
  4. Mr Zombie

    Thanks Cerridwen.

    Tax always makes things more complicated than it needs to be. When I studied tax a while back it used to wind me up how they made such a simple concept so difficult.

    Mr Z

    Reply
  5. TulipCraze

    However the government will certainly fiddle with pensions in the future to make them less attractive. I think it likely there will be some combination of the following:
    -Reducing the benefit for higher rate tax payers
    -Reducing the limit from 40k/year
    -Continuing "Fiscal Drag" in not raising the higher rate tax limit.
    ….

    Reply
  6. TulipCraze

    However the government will certainly fiddle with pensions in the future to make them less attractive. I think it likely there will be some combination of the following:
    -Reducing the benefit for higher rate tax payers
    -Reducing the limit from 40k/year
    -Continuing "Fiscal Drag" in not raising the higher rate tax limit.
    ….

    Reply
  7. Mr Zombie

    Hi TC,
    Thanks for the comment.
    Yeah – it is an ever present risk (for the ISA as well to some extent) that governments may tinker with it to get some easy tax income. That said, with the changes in April making the pension much more flexible I do wonder if we will see a situation where the pension and ISA products become more similar. Or maybe they are banking on most people taking all of their drawdown at once and incurring a higher tax….

    Mr Z

    Reply
  8. ermine

    > The ISA's Holy Hand Grenade: Diversification
    You don't have to hold all of your ISA investments with the one broker. In my eyes this is a huge benefit.

    Eh? There is absolutely no law against you holding more than one SIPP, indeed unlike an ISA you can even contribute ot more than one at once.

    In practice you need to do both ISA and SIPP if you are looking to become financially independent before the age you can draw pension savings (currently 55 but rising to 57 soon)

    So you need to save with both time horizons in mind – use the pension for the bulk long-term savings but you need the ISA to bridge the gap between FI and 57. In theory you can run the ISA capital into the ground by 57 because the pension can do the lifting after then and your 25% pension commencement lump sum will get your savings back. Spin that on book1.xlsx one day – it's not one or the other.

    You need both, and early retirees need to compute the balance right else they will either suffer an income suckout FI until 57 if they are short ISA savings and can't get hold of the money in their SIPP or end up paying more tax if they overcook the ISA part, because you pay a lot less tax with a pension of you are basic rate on drawing it.

    This is what spreadsheets are for – and I know because I screwed this up, so I have the income suckout for a little while.

    Reply
  9. Mr Zombie

    Hi Ermine,
    I wasn't particularly clear on that part, I was only talking about my company pension in this regard. Although it doesn't have the largest amount of options for investing, it is cheap and I get a fairly generous employers contribution. I am pretty sure that I wouldn't get the employers contribution if I moved to a SIPP (conditions of my scheme, I don't think there is anything to stop an employer contributing to a SIPP.)

    [As an aside I wonder if there is a way to transfer out part of a pension, e.g. from a company pension into a SIPP. The transfer out forms I have seen are just for the whole amount. Research time!]

    Your point about the right split between the ISA and the SIPP is a conundrum (especially if you are paying higher rate and will be drawing down on BR). This split is something that I have been thinking about, only recently. My problem was getting out of the mindset that a pension is the only vehicle for retirement. While I was saving away quite happily into the company scheme, the thought of retiring early hadn't really crossed my mind until I stumbled across an FI blog that then opened up many more.

    Poor book1 will be helping me get my head around the split a bit better in the coming weeks 🙂

    Sorry to hear about the income suckout, although I guess better to have a few years like this with an early escape and pension savings to be accessed in the future, than working far longer without having saved enough for retirement of any kind!

    Thanks

    Mr Z

    Reply

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